17 April 2018 IRS outlines remedial actions to protect bonds' tax-advantaged status when nonqualified use occurs In Revenue Procedure 2018-26 (the Revenue Procedure), the IRS has set forth remedial actions that issuers of tax-advantaged bonds may take to preserve the tax-advantaged status of the bonds when nonqualified use of the bond proceeds occurs. State and local governments and other qualified issuers can issue tax-exempt or tax-advantaged bonds to benefit from the lower borrowing costs that such tax-advantaged bonds provide. Certain nonqualified uses of the proceeds of those bonds, however, may cause the bonds to lose their tax-advantaged status. Existing regulations include some provisions to cure certain nonqualified uses, but do not include remedial actions for other nonqualified uses, including: 1. Curing the nonqualified uses that generally result from longer-term leases of financed property to private businesses, other than the remedial action of bond redemption or defeasance 2. Allowing, for direct pay bonds, adjustment of the refundable federal tax credit for nonqualified uses Furthermore, the existing regulations do not make remedial actions available for certain types of tax credit bonds or for direct pay bonds. The Revenue Procedure provides specific remedial actions to allow issuers to protect the tax-advantaged status of their bonds under certain circumstances when nonqualified uses of bond proceeds occur. The Revenue Procedure applies to a nonqualified use that occurs on or after April 11, 2018, and may be applied to a nonqualified use occurring before that date. The Revenue Procedure sets forth remedial actions to cure the nonqualified use of tax-advantaged bonds resulting from a deliberate action involving an "eligible lease" to a nongovernmental person of property financed with tax-advantaged bonds that are subject to the private activity bond restrictions under Section 141 or Section 145(a). Specifically, the Revenue Procedure states that the nonqualified use resulting from the lease may be cured by applying the alternative use of disposition proceeds remedial action under Reg. Section 1.141-12(e), in the same manner as to a disposition but with certain specified modifications. These modifications include: 2. Treating funds (excluding proceeds of tax-advantaged bonds) in an amount equal to the "lease amount" (as defined in the Revenue Procedure) as disposition proceeds 4. Allocating proceeds of the issue that are allocable to the funds treated as disposition proceeds, to those funds during the term of the lease only (and to the leased property thereafter) For these purposes, the Revenue Procedure outlines certain requirements for a lease to be considered an "eligible lease," and defines the relevant "lease amount." An eligible lease is generally one for which: — Is the lesser of 20 years or 75% of the leased property's weighted average reasonably expected economic life or The private business use measurement period under Reg. Section 1.141-3(g)(2) is generally the earlier of the last date of the property's reasonably expected economic life or the latest maturity date of any bond of the issue financing the property. The lease amount equals the present value of all of the lease payments required to be made under the lease. The Revenue Procedure allows an issuer to cure a nonqualified use relating to direct pay bonds by reducing the amount of the refundable federal tax credit to eliminate the amount allocable to the nonqualified bonds. To effect this remedial action, the Revenue Procedure instructs issuers to follow certain reporting instructions, beginning with the first Form 8038-CP (Return for Credit Payment to Issuers of Qualified Bonds) or any successor form filed for any interest payment date for the bonds after the nonqualified use occurs. Specifically, the Revenue Procedure states that an issuer, in reporting the amount of the interest payable, must exclude that portion of the interest allocable to the nonqualified bonds that accrues on or after the date of the nonqualified use. In addition, for the first such Form 8038-CP, the issuer must print or type across the top of the form "Remedial Action under Section 6 of Revenue Procedure 2018-26" and attach the required explanation for the difference in scheduled credit payment. The explanation must state that a nonqualified use occurred and the date of the nonqualified use. It must also include a revised debt service schedule reflecting the exclusion of amounts allocable to the nonqualified bonds beginning with the date of the nonqualified use. Subject to certain exceptions, the Revenue Procedure sets forth remedial actions that issuers may take to cure a nonqualified use in the case of tax-credit bonds or direct pay bonds. Specifically, the Revenue Procedure sets forth two such remedial actions: Regarding the remedial action of redemption or defeasance of nonqualified bonds, Section 7.02 the Revenue Procedure outlines a number of specific requirements on the amount and timing of redemption or defeasance, yield restriction or rebate requirement, and treatment of disposition proceeds. Section 7.05 outlines the requirements for the remedial action for alternative use of disposition proceeds. Specific requirements apply to dispositions of cash, reasonably expected use of disposition proceeds, unspent disposition proceeds and treatment of disposition proceeds. This Revenue Procedure comes as welcome news to organizations that lease certain facilities financed with qualified tax-exempt bonds. While the Revenue Procedure affects various remedial actions, the provisions with the broadest implications for tax-exempt organizations are the new rules regarding leases that result in non-qualified use. These rules are meant to be similar to the remedial action procedures for a disposition of tax-exempt bond-financed property to a non-qualified user. Generally, if an organization sold or otherwise disposed of a facility financed with qualified private activity bonds, including qualified tax-exempt Section 501(c)(3) bonds, this would violate the qualified use tests under Section 145(a), causing the bonds to lose their tax-advantaged status. Certain remedial actions, however, are available to the issuer or conduit borrower in these instances that could prevent the bonds from losing their tax-exempt status. Upon a disposition to a nonqualified user, to cure the failure of the ownership test, the organization could either: (a) sell the facility to the nonqualified user exclusively for cash, (b) use the proceeds of the sale for a qualified use within two years, or (c) defease the outstanding bonds. Before the Revenue Procedure, the only remedial action available for long-term leases to nonqualified users was timely defeasance of the bond issue. Now, under the Revenue Procedure, these same options for remedial action generally apply to long-term leases of tax-exempt bond financed facilities to non-qualified users, with a few modifications, which work to effectively treat the lease proceeds as disposition proceeds under Reg. Section 1.141-12(e). The Revenue Procedure also updated remedial actions allowing issuers of direct pay bonds to reduce their non-refundable federal tax credit to offset nonqualified use. Lastly, the Revenue Procedure offers remedial actions not previously available to tax-credit or direct pay bonds when a deliberate nonqualified use occurs, including redemption or defeasance of nonqualified bonds and alternative use of disposition proceeds within two years. Both provisions will enable tax-exempt borrowers to resolve matters regarding nonqualified use in an efficient manner. For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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