Source: https://www.irs.gov/irb/2016-10_IRB/ar17.html
Timestamp: 2017-03-25 09:47:35
Document Index: 711137997

Matched Legal Cases: ['art 1', '§1', '§1', '§1', '§1', '§ 1', '§ 1', '§1', '§ 601']

Internal Revenue Bulletin - March 7, 2016 - REG–129067–15
Internal Revenue Bulletin: 2016-10 March 7, 2016 REG–129067–15
This document contains proposed regulations that provide guidance regarding the definition of political subdivision for purposes
of tax-exempt bonds. The proposed regulations are necessary to specify the elements of a political subdivision. The proposed
regulations will affect State and local governments that issue tax-exempt bonds and users of property financed with tax-exempt
bonds. Under certain transition rules, however, the proposed definition of political subdivision will not apply for determining
whether outstanding bonds are obligations of a political subdivision and will not apply to existing entities for a transition
period. This document also provides a notice of a public hearing for these proposed regulations.
Written or electronic comments must be received by May 23, 2016. Request to speak and outlines of topics to be discussed at
the public hearing scheduled for June 6, 2016, at 10:00 a.m., must be received by May 23, 2016.
Send submissions to: CC:PA:LPD:PR (REG–129067–15), Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington,
to CC:PA:LPD:PR (REG–129067–15), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or
sent electronically via the Federal eRulemaking Portal at www.regulations.gov (REG–129067–15). The public hearing will be
held at the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.
Concerning the proposed regulations, Spence Hanemann at (202) 317-6980; concerning submissions of comments and the hearing,
Oluwafunmilayo (Funmi) Taylor at (202) 317-6901 (not toll-free numbers).
This document contains proposed amendments to 26 CFR part 1 under section 103 of the Internal Revenue Code (Code). Section
103 generally provides that, with certain exceptions, gross income does not include interest on any obligation of a State
or political subdivision thereof. Section 1.103–1 of the Income Tax Regulations (the Existing Regulations) defines political
subdivision as “any division of any State or local governmental unit which is a municipal corporation or which has been delegated
the right to exercise part of the sovereign power of the unit.”
On a few occasions, Federal courts have ruled on whether an entity qualifies as a political subdivision. E.g., Philadelphia Nat'l Bank v. United States, 666 F.2d 834 (3d Cir. 1981); Comm'r of Internal Revenue v. White's Estate, 144 F.2d 1019 (2d Cir. 1944). The IRS has also addressed this issue in revenue rulings, most recently in 1983. E.g., Rev. Rul. 83–131 (1983–2 CB 184); Rev. Rul. 78–138 (1978–1 CB 314). Because the results in these revenue rulings generally
turn on the unique facts and circumstances of the individual cases, numerous entities have sought and received letter rulings
on whether they are political subdivisions. Letter rulings, however, are limited to their particular facts, may not be relied
upon by taxpayers other than the taxpayer that received the ruling, and are not a substitute for published guidance. See 26 U.S.C. 6110(k)(3) (2015) (providing generally that a ruling, determination letter, or technical advice memorandum may
not be used or cited as precedent).
Commenters have requested additional published guidance, to be applied prospectively, on which facts and circumstances are
germane to an entity's status as a political subdivision. The Treasury Department and IRS recognize the need to clarify the
definition of political subdivision to provide greater certainty to prospective issuers and to promote greater consistency
in how the definition is applied across a wide range of factual situations. These proposed regulations (the Proposed Regulations)
would provide a new definition of political subdivision for purposes of tax-exempt bonds and would update and streamline other
portions of the Existing Regulations. The definition of political subdivision in the Proposed Regulations does not apply in
determining whether an entity is treated as a political subdivision of a State for purposes of section 414(d) of the Code.
The Proposed Regulations clarify and further develop the eligibility requirements for a political subdivision. To qualify
as a political subdivision under the Proposed Regulations, an entity must meet three requirements, taking into account all
of the facts and circumstances: sovereign powers, governmental purpose, and governmental control. The Proposed Regulations
also authorize the Commissioner to set forth in future guidance to be published in the Internal Revenue Bulletin additional
circumstances in which an entity qualifies as a political subdivision.
The Proposed Regulations continue, without substantive change, the longstanding requirement that a political subdivision be
empowered to exercise at least one of the generally recognized sovereign powers. The three sovereign powers recognized for
this purpose are eminent domain, police power, and taxing power. See Comm'r of Internal Revenue v. Shamberg's Estate, 144 F.2d 998 (2d Cir. 1944). The entity must be able to exercise a substantial amount of at least one of these powers. See, e.g., Rev. Rul. 77–164 (1977–1 CB 20); Rev. Rul. 77–165 (1977–1 CB 21).
In determining whether an entity is a political subdivision, the case law and administrative guidance interpreting the definition
of political subdivision in the Existing Regulations commonly consider whether the entity serves a public purpose. Historically,
the determination of whether an entity serves a public purpose has focused on the purpose for which the entity was created,
usually as set forth in the legislation authorizing creation of the entity, rather than on the entity's conduct after its
creation. See, e.g., Shamberg's Estate, 144 F.2d at 1004. The Proposed Regulations require that a political subdivision serve a governmental purpose. A governmental
purpose requires, among other things, that the purpose for which the entity was created, as set out in its enabling legislation,
be a public purpose and that the entity actually serve that purpose. It also requires that the entity operate in a manner
that provides a significant public benefit with no more than incidental benefit to private persons. Cf., Rev. Rul. 90–74 (1990–2 CB 34) (applying an “incidental private benefit” standard for purposes of determining whether income
is included in gross income under section 115(1)).
The Proposed Regulations provide that a political subdivision must be governmentally controlled. The Proposed Regulations
provide rules for determining both what constitutes control and which parties must possess that control.
The Proposed Regulations define control to mean ongoing rights or powers to direct significant actions of the entity. Rights
or powers to direct the entity's actions only at a particular point in time are not ongoing and, therefore, do not constitute
control. For example, the right to approve an entity's plan of operation as a condition of the entity's formation is not an
ongoing right. To constitute control, a collection of rights and powers must enable its holder to direct the significant actions
The Proposed Regulations provide three non-exclusive benchmarks of rights or powers that constitute control: (1) the right
or power both to approve and to remove a majority of an entity's governing body; (2) the right or power to elect a majority
of the governing body of the entity in periodic elections of reasonable frequency; or (3) the right or power to approve or
direct the significant uses of funds or assets of the entity in advance of that use. Aside from these three arrangements,
the determination of whether a collection of rights and powers constitutes control will depend on the facts and circumstances.
Neither the right to dissolve an entity nor procedures designed to ensure the integrity of the entity but not to direct significant
actions of the entity are control. Cf., Rev. Rul. 69–453 (1969–2 CB 182) (addressing procedures that do not constitute control in the context of instrumentalities).
Control by a small faction of private individuals, business corporations, trusts, partnerships, or other persons is fundamentally
not governmental control. Therefore, the Proposed Regulations generally require that control be vested in either a general
purpose State or local governmental unit or in an electorate established under an applicable State or local law of general
application. If, however, a small faction of private persons controls an electorate, that electorate's control of the entity
does not constitute governmental control of the entity. Accordingly, the Proposed Regulations provide that an entity controlled
by an electorate is not governmentally controlled when the outcome of the exercise of control is determined solely by the
votes of an unreasonably small number of private persons.
The determination of whether the number of private persons controlling an electorate is unreasonably small generally depends
on all of the facts and circumstances. To provide certainty, the Proposed Regulations limit application of this facts and
circumstances test to situations that fall between two quantitative measures of concentration in voting power. The number
of private persons controlling an electorate is always unreasonably small if the combined votes of the three voters with the
largest shares of votes in the electorate will determine the outcome of the relevant election, regardless of how the other
voters vote. The number of private persons controlling an electorate is never unreasonably small if determining the outcome
of the relevant election requires the combined votes of more voters than the 10 voters with the largest shares of votes in
the electorate. For example, control can always be vested in any electorate comprised of 20 or more voters that each have
the right to cast one vote in the relevant election without giving rise to a private faction. For purposes of applying these
measures of concentration in voting power, related parties are treated as a single voter and the votes of the related parties
Some observers have suggested that, despite private control, development districts should be political subdivisions during
an initial development period in which one or two private developers elect the district's governing body and no other governmental
control exists. The Treasury Department and IRS recognize that the governmental control requirement may present challenges
for such development districts. In these circumstances, the Treasury Department and IRS are concerned about the potential
for excessive private control by individual developers, the attendant impact of excessive issuance of tax-exempt bonds, and
inappropriate private benefits from this Federal subsidy. The Treasury Department and IRS seek public comment on whether it
is necessary or appropriate to permit such districts to be political subdivisions during an initial development period; how
such relief might be structured; what specific safeguards might be included in the recommended relief to protect against potential
abuse; and whether the proposed prospective effective dates and transition periods in §1.103–1(d) of the Proposed Regulations
provide sufficient relief.
In addition to amending the definition of political subdivision, paragraphs (a) and (b) of the Proposed Regulations update
the references in the general provisions of the Existing Regulations to reflect changes to the Code made in the Tax Reform
Act of 1986, Public Law 99–514, 100 Stat. 2085, and other laws and regulations since the promulgation of the longstanding
Existing Regulations. The Proposed Regulations also streamline these provisions. In general, the Treasury Department and the
IRS intend that these proposed amendments not change the meaning of the Existing Regulations. The last sentence of §1.103–1(a)
of the Proposed Regulations, however, clarifies that the continued tax-exemption of an issue of bonds depends on its issuer's
continued status as a qualifying issuer of tax-exempt bonds. The Treasury Department and IRS seek comments on the need for
remedial action provisions in the event the entity ceases to qualify as a political subdivision and on the substance of any
Subject to certain transition rules, the Proposed Regulations generally would apply to all entities for all purposes of the
tax-exempt bond provisions of sections 103 and 141 to 150 beginning 90 days after the Proposed Regulations are finalized.
In order to ease hardship that may arise from the new definition of political subdivision, under proposed transition rules,
that definition would not apply for purposes of determining whether outstanding bonds and refunding bonds in which the weighted
average maturity is not extended continue to be obligations of a political subdivision. While these transition rules for outstanding
bonds and refunding bonds would apply for the purpose of determining whether these bonds continue to be obligations of a political
subdivision, the new proposed definition of political subdivision would apply for other purposes under sections 103 and 141
to 150, such as whether a new entity that subsequently became a user of a project financed with such bonds qualified as a
State or local governmental unit for purposes of section 141. Furthermore, under another proposed transition rule that would
apply to entities in existence prior to 30 days after the Proposed Regulations are published, the proposed definition of political
subdivision would not apply for any purpose until three years and ninety days after the Proposed Regulations are finalized.
This three-year transition period provides existing entities an opportunity to restructure as necessary to satisfy the new
definition of political subdivision and allows existing entities to continue to issue new bonds during the transition period.
To enhance certainty, an issuer also may choose to apply the definition of political subdivision in §1.103–1(c) in the final
regulations in circumstances in which that definition otherwise would not apply under the transition rules.
In addition, prior to the applicability date of the final regulations, issuers may elect to apply the definition of political
subdivision in §1.103–1(c) of the Proposed Regulations in whole, but not in part, for any purpose of sections 103 and 141
through 150, provided such use is applied consistently for all purposes of sections 103 and 141 through 150 to any given entity.
Counsel for Advocacy of the Small Business Administration for comment on its impact on small entities.
A public hearing has been scheduled for June 6, 2016, at 10:00 a.m., in the Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue
an outline of the topics to be discussed and the time to be devoted to each topic by May 23, 2016. Submit a signed paper or
electronic copy of the outline as prescribed in this preamble under the “Addresses” heading. A period of 10 minutes will be
allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline
for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.
The principal authors of these regulations are Spence Hanemann and Timothy Jones, Office of Associate Chief Counsel (Financial
IRS revenue rulings cited in this notice of proposed rulemaking are made available by the Superintendent of Documents, U.S.
Par. 2. Section 1.103–1 is revised to read as follows:
§ 1.103–1 Interest on State or local bonds.
(a) Interest on State or local bonds. Under section 103(a), except as otherwise provided in section 103(b), gross income does not include interest on any State
or local bond. Under section 103(c), the term State or local bond means any obligation (as defined in § 1.150–1(b)) of a State (including for this purpose the District of Columbia or any
possession of the United States) or a political subdivision thereof (a State or local governmental unit). Obligations issued
by or on behalf of any State or local governmental unit by a constituted authority empowered to issue such obligations are
the obligations of such a unit. An obligation qualifies as a State or local bond so long as the issuer of that obligation
remains a State or local governmental unit or a constituted authority.
(b) Certain limitations on interest exclusion. Under section 103(b), the interest exclusion in section 103(a) is inapplicable to a private activity bond under section
141(a) (unless the bond is a qualified bond under section 141(e)), an arbitrage bond under section 148, or a bond which does
not meet the applicable requirements of section 149.
(c) Definition of political subdivision—(1) In general. The term political subdivision means an entity that meets each of the requirements of paragraphs (c)(2) (sovereign powers), (c)(3) (governmental purpose),
and (c)(4) (governmental control) of this section, taking into account all of the facts and circumstances, or that is described
in published guidance issued pursuant to paragraph (c)(5) of this section. Entities that may qualify as political subdivisions
include, among others, general purpose governmental entities, such as cities and counties (whether or not incorporated as
municipal corporations), and special purpose governmental entities, such as special assessment districts that provide for
roads, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port improvements, and other governmental
purposes for a State or local governmental unit.
(2) Sovereign powers. Pursuant to a State or local law of general application, the entity has a delegated right to exercise a substantial amount
of at least one of the following recognized sovereign powers of a State or local governmental unit: the power of taxation,
the power of eminent domain, and police power.
(3) Governmental purpose. The entity serves a governmental purpose. The determination of whether an entity serves a governmental purpose is based
on, among other things, whether the entity carries out the public purposes that are set forth in the entity's enabling legislation
and whether the entity operates in a manner that provides a significant public benefit with no more than incidental private
(4) Governmental control. A State or local governmental unit exercises control over the entity. For this purpose, control is defined in paragraph
(c)(4)(i) of this section and a State or local governmental unit exercises such control only if the control is vested in persons
described in paragraph (c)(4)(ii) of this section.
(i) Definition of control. Control means an ongoing right or power to direct significant actions of the entity. Rights or powers may establish control either
individually or in the aggregate. Among rights or powers that may establish control, an ongoing ability to exercise one or
more of the following significant rights or powers, on a discretionary and non-ministerial basis, constitutes control: the
right or power both to approve and to remove a majority of the governing body of the entity; the right or power to elect a
majority of the governing body of the entity in periodic elections of reasonable frequency; or the right or power to approve
or direct the significant uses of funds or assets of the entity in advance of that use. Procedures designed to ensure the
integrity of the entity but not to direct significant actions of the entity are insufficient to constitute control of an entity.
Examples of such procedures include requirements for submission of audited financial statements of the entity to a higher
level State or local governmental unit, open meeting requirements, and conflicts of interest limitations.
(A) A State or local governmental unit possessing a substantial amount of each of the sovereign powers and acting through
its governing body or through its duly authorized elected or appointed officials in their official capacities; or
(B) An electorate established under applicable State or local law of general application, provided the electorate is not a
private faction (as defined in paragraph (c)(4)(iii) of this section).
(iii) Definition of private faction—(A) In general. A private faction is any electorate if the outcome of the exercise of control described in paragraph (c)(4)(i) of this section is determined
solely by the votes of an unreasonably small number of private persons. The determination of whether a number of such private
persons is unreasonably small depends on all of the facts and circumstances, including, without limitation, the entity's governmental
purpose, the number of members in the electorate, the relationships of the members of the electorate to one another, the manner
of apportionment of votes within the electorate, and the extent to which the members of the electorate adequately represent
the interests of persons reasonably affected by the entity's actions. For purposes of this definition, the special rules in
paragraphs (c)(4)(iii)(B) through (D) of this section apply.
(B) Treatment of certain limited electorates as private factions. An electorate is a private faction if any three private persons that are members of the electorate possess, in the aggregate,
a majority of the votes necessary to determine the outcome of the relevant exercise of control.
(C) Safe harbor—voting power dispersed among more than 10 persons. An electorate is not a private faction if the smallest number of private persons who can combine votes to establish a majority
of the votes necessary to determine the outcome of the relevant exercise of control is greater than 10 persons. For example,
if an electorate consists of 20 private persons with equal, five-percent shares of the total votes, that electorate is not
a private faction because a minimum of 11 members of that electorate is necessary to have a majority of the votes. By contrast,
for example, if an electorate consists of 20 private persons with unequal voting shares in which some combination of 10 or
fewer members has a majority of the votes, then that electorate does not qualify for the safe harbor from treatment as a private
faction under this paragraph (c)(4)(iii)(C).
(D) Operating rules. The following rules apply for purposes of determining numbers of voters and voting control in paragraphs (c)(4)(iii)(B)
and (C) of this section: (1) Related parties (as defined in §1.150–1(b)) are treated as a single person; and
(2) In computing the number of votes necessary to determine the outcome of the relevant exercise of control, all voters entitled
to vote in an election are assumed to cast all votes to which they are entitled.
(5) Authority of the Commissioner. In guidance published in the Internal Revenue Bulletin, the Commissioner may set forth additional circumstances in which
an entity qualifies as a political subdivision of a State or local governmental unit. See § 601.601(d)(2)(ii) of this chapter.
(d) Applicability dates—(1) In general. Except as otherwise provided in paragraphs (d)(2) through (4) of this section, this section applies to all entities for
all purposes of sections 103 and 141 through 150 beginning on the date 90 days after the publication of the Treasury decision
adopting these rules as final regulations in the Federal Register.
(2) Applicability date of the definition of political subdivision for outstanding bonds. For purposes of determining whether outstanding bonds of an entity are obligations of a political subdivision under section
103, the definition of political subdivision in paragraph (c) of this section does not apply to that entity with respect to
its outstanding bonds that are issued before the general applicability date under paragraph (d)(1) of this section.
(3) Applicability date of the definition of political subdivision for refunding bonds. For purposes of determining whether refunding bonds of an entity are obligations of a political subdivision under section
its refunding bonds that are issued on or after the general applicability date under paragraph (d)(1) of this section to refund
bonds with respect to which paragraph (c) of this section otherwise does not apply, provided that the weighted average maturity
of the refunding bonds is no longer than the remaining weighted average maturity of the refunded bonds.
(4) Applicability date of the definition of political subdivision for existing entities. For existing entities that are created or organized before May 21, 2016, the definition of political subdivision in paragraph
(c) of this section does not apply for any purpose of sections 103 and 141 to 150 during the three-year period beginning on
the general applicability date under paragraph (d)(1) of this section.
(5) Elective application of definition of political subdivision. An issuer may choose to apply the definition of political subdivision in paragraph (c) of this section to an issue of bonds
in circumstances in which that section otherwise would not apply to that issue under paragraph (d)(2) or (3) of this section,
provided that choice is applied consistently to the issue. An entity may choose to apply the definition of political subdivision
in paragraph (c) of this section to an entity in circumstances in which that section otherwise would not apply to that entity
under paragraph (d)(4) of this section, provided that choice is applied consistently to the entity.
(Filed by the Office of the Federal Register on February 22, 2016, 8:45 a.m., and published in the issue of the Federal Register
for February 23, 2016, 81 F.R. 03790)