Court Opinion

ID: 4334384
Source: CourtListenerOpinion
Date Created: 2018-11-14 01:38:43.638705+00
Date Added: 2024-06-11T14:19:57.057814
License: Public Domain

120 T.C. No. 12

                UNITED STATES TAX COURT

     CITY OF SANTA ROSA, CALIFORNIA, Petitioner v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7310-00B.                Filed May 13, 2003.

     P petitions this Court pursuant to sec. 7478,
I.R.C., seeking a declaration that interest on certain
bonds will be exempt from taxation under sec. 103(a),
I.R.C. P proposes to issue bonds of $140 million to
finance the construction of a pipeline. The pipeline
will dispose of wastewater generated in P’s subregional
sewage and water reclamation system. P has entered
into an agreement obligating P to deliver, and a
utility company to accept, an average of 11 million
gallons of wastewater per day. The utility company
will use the wastewater to activate geysers and produce
steam for the generation of electricity. P will
receive no payments from the utility company for the
wastewater. P will enter into agreements with
irrigators along the pipeline obligating P to supply
wastewater for consideration not to exceed 5 percent of
the debt service on the bonds. At least 95 percent of
the debt service on the bonds will be paid by sewer
demand fees imposed on users of P’s sewage system. The
sewage ratepayers use the pipeline as members of the
general public. The pipeline is an integral part of
                                - 2 -

     P’s sewage system, and it was constructed for the
     purpose of disposing of the wastewater generated in P’s
     sewage treatment process.

          R determined that the bonds will be private
     activity bonds under sec. 141(b)(1) and (2), I.R.C.,
     and that interest on the bonds will not be exempt from
     taxation under sec. 103(a), I.R.C.

          Held: Private business use does not exceed 10
     percent of the proceeds of the bond issue. The private
     business use test of sec. 141(b)(1), I.R.C., is not
     met. The proposed bonds are not private activity
     bonds, and interest on those bonds will be excludable
     under sec. 103(a), I.R.C.

     David L. Miller and David A. Walton, for petitioner.

     Gary W. Bornholdt and Timothy L. Jones, for respondent.

                               OPINION

     RUWE, Judge:   This is an action for declaratory judgment

pursuant to section 7478.1   Petitioner requested a ruling from

respondent that interest on bonds it proposes to issue will be

excludable from gross income under section 103(a), and that the

proposed bonds will not be private activity bonds within the

meaning of section 141(a).   Respondent determined that the

proposed bonds will constitute private activity bonds, and any

interest on the proposed bonds will not be excludable from gross

income under section 103(a).   The issue for decision is whether

     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code currently in effect, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
                              - 3 -

interest on the proposed bonds will be excludable from the gross

income of prospective bondholders under section 103(a).

                           Background

     This case was submitted fully stipulated under Rule 122.

The stipulation of facts, the stipulation as to administrative

record, and the attached exhibits are incorporated herein by this

reference.

     Petitioner is a political subdivision of the State of

California and has taxing powers, police powers, and powers of

eminent domain under the constitution and laws of that State.

Petitioner owns and operates a subregional sewage and water

reclamation system, which includes facilities for collection and

treatment of sewage and other effluent, tertiary treatment of the

wastewater produced therefrom, a reservoir for storing

wastewater, pipelines, and other facilities for the

transportation of wastewater to discharge points.2    This system

serves approximately 250,000 people in central Sonoma County,

California, including the cities of Santa Rosa, Rohnert Park,

Cotati, and Sebastopol, as well as a portion of the

unincorporated area of Sonoma County.   As of July 31, 1996, the

system had a capacity for 18 million gallons of wastewater per

day, which was disposed of by means of urban irrigation, created

     2
      Wastewater or effluent generated by petitioner’s sewage
treatment process receives tertiary treatment under California
Department of Health Services standards before any discharge.
                               - 4 -

wetlands in the Santa Rosa Plain, agricultural irrigation, and

discharge to the Russian River via the Laguna de Santa Rosa.3

     In recent years, population growth and other factors

prompted petitioner to find other alternatives for disposal of

wastewater.   On April 18, 1995, the Santa Rosa City Council

agreed to consider five alternatives to deal with the increasing

amounts of wastewater:

     Alternative 1:   No Action (No Project).

     Alternative 2: South County Reclamation; agricultural
     irrigation and associated reclaimed water storage in
     areas south of Santa Rosa.

     Alternative 3: West County Reclamation; agricultural
     irrigation and associated reclaimed water storage in
     areas west of Santa Rosa.

     Alternative 4: Geysers Recharge; injection of
     reclaimed water for recharge of the Geysers steamfield
     located in northeastern Sonoma County.

     Alternative 5: Discharge; release of reclaimed water
     to the Russian River or Laguna de Santa Rosa at a
     design discharge rate of up to 20 percent of river
     flow.

After those alternatives were discussed and considered,

petitioner chose a modified form of alternative 4, the “Geysers

     3
      According to a document entitled “Comparison of
Alternatives and Statement of Overriding Considerations”:

     The current Basin Plan limits Russian River discharges
     to 1% of the flow at the point of discharge, and the
     City of Santa Rosa is operating under an interim permit
     granting discharge at up to 5% discharge of Russian
     River flow with permission from the Executive Officer
     of the Regional Water Quality Control Board.
                               - 5 -

Alternative”, which provides for the disposal of wastewater

through a pipeline to various electric utility, industrial,

agricultural, commercial, residential, and other users.     Under

this proposal, a pipeline, four pumping stations, tanks,

connection equipment, control systems, power systems, and a

storage tank will be constructed.    The pipeline will be

constructed in two sections.   The first section will run from the

sewage treatment plant and reservoir to the base of a mountain, a

distance of 29 miles.   This section will have a capacity of 40

million gallons of wastewater per day.     The second section will

run a distance of 12 miles from the base to the top of the

mountain, where a thermally active geyser steamfield is located.

This section will have a capacity of 12.1 million gallons of

wastewater per day.

     On April 14, 1998, petitioner entered into an agreement with

Union Oil Co. of California, NEC Acquisition Co., and Thermal

Power Co. (collectively Company).4     Petitioner agreed to deliver

to Company approximately 11 million gallons of wastewater per day

over the 30-year term of the contract.5     In exchange, Company

agreed to accept approximately 11 million gallons of wastewater

     4
      Company is a “nongovernmental person” under sec. 141 and
the regulations.
     5
      The agreement speaks in terms of an “Annual Amount” and
obligates petitioner to deliver, and Company to accept, 4,015
million gallons of wastewater each year (an average of 11 million
gallons per day).
                               - 6 -

per day and also agreed to provide the electricity necessary to

operate three of petitioner’s pumping stations.   The wastewater

must meet the California Department of Health Services standards

for tertiary treatment, and Company will have the right to access

petitioner’s facilities and records to test the water or verify

its quality.   Company will pay no fees, directly or indirectly,

to petitioner for use of the wastewater.

     Company will use the wastewater to generate electricity for

sale to customers.   To do so, Company has to take the wastewater

and inject it into the ground where the wastewater will become

heated and produce steam.   Petitioner will not receive any

revenues from or other interest in Company’s electricity

operation.   Petitioner will provide all labor, materials, and

capital for the construction, operation, and maintenance of the

pipeline and related facilities from the existing sewage system

to a “point of delivery connection”.6   Company will provide all

labor, materials, and capital for the construction, operation,

and maintenance of additional pipeline and related facilities

from the point of delivery, as well as the electric supply

facilities for three of the four pumping stations along the

     6
      Petitioner is obligated to supply the wastewater at a
“point-of-delivery connection”. The agreement defines the term
“point of delivery” as “the point at which * * * [petitioner]
delivers water to * * * [Company] located at the discharge flange
of the storage distribution tanks”.
                                 - 7 -

pipeline.7 Company will own or lease the geyser steamfield, the

facilities for injecting the wastewater into the ground, the

facilities for generating electricity, and the electric supply

facilities for the pumping stations.

     According to the agreement, a failure by either party to

receive or deliver the obligated amounts of wastewater will

require mediation.   If mediation fails, the nondefaulting party

can either declare the defaulting party in breach of the contract

or seek specific performance.8    If Company should breach the

contract within the first 20 years of its term, petitioner can

terminate the contract and collect liquidated damages of $3

million for each year remaining on the contract up to a maximum

of 10 years.   During the last 10 years of its term, Company can

terminate the contract at any time provided it gives notice to

petitioner and pays $3 million for each year remaining in the

contract’s term.   Petitioner does not expect that the contract

with Company will be breached by either party or that Company

will pay petitioner any liquidated damages.

     7
      The agreement states: “[Company] shall provide the
electricity, at no cost to * * * [petitioner], to operate pumping
stations two, three and four, or any substitute stations.” The
three pumping stations will pump the wastewater uphill to the
point of delivery.
     8
      A nondefaulting party can request a temporary restraining
order and a preliminary injunction to prevent a default under the
agreement or to compel performance.
                              - 8 -

     Of the 40 million gallons of wastewater per day that could

conceivably pass through the first section of pipeline,

approximately 29 million gallons will be available for various

users (irrigators) along its route.9   Those users are expected to

consist of vineyards and other growers, ranchers, homeowners in

large rural settings, parks, and others.   Petitioner intends to

enter into agreements with the irrigators for periods of 10 to 20

years, which will guarantee a certain amount of wastewater at a

negotiated cost to the irrigators.10   Petitioner’s ruling request

represents that “Aggregate amounts received from the Irrigation

Contracts will not exceed 5 percent of debt service on the

Bonds.”

     General rates and charges (sewer demand fees) are presently

imposed on users of petitioner’s sewage system.   The various fees

are set by an ordinance which provides a generally applicable

     9
      This assumes 11 million gallons per day of wastewater will
be transported to the geyser steamfield for use by Company.
However, an exhibit entitled “Table of Delivery Rates” shows that
estimated flows of wastewater per day to the geyser steamfield
will range from 9.0 million gallons in April and May to 12.1
million gallons in November, December, and January.
     10
      According to petitioner, irrigators must take water from
the pipeline in the winter and spring when greater amounts of
wastewater are available and fill ponds and reservoirs for future
use. It is unlikely that those users will have ponds or
reservoirs currently in place, and each user could incur
significant capital expenditures for construction of ponds and
reservoirs, as well as the related pumping and connection
equipment. Those users will want assurances that the pipeline
will be built and that they will be guaranteed a certain amount
of the wastewater.
                                - 9 -

published rate schedule.    There are no specially negotiated rate

arrangements for the disposal of sewage among users of the sewage

system.    The sewage disposal functions of petitioner’s sewage

system are available for general public use.     The sewer demand

fees will secure and will be used to pay the debt service on the

bonds.    Debt service on the bonds will require petitioner to

increase the sewer demand fees.    Petitioner expects, as of the

issue date, that the sewer demand fees will pay more than 95

percent of the debt service on the bonds.

     On June 2, 1998, petitioner adopted a resolution authorizing

the issuance of bonds (Series 1998A bonds).     On September 17,

1998, petitioner issued taxable bonds of $31 million, the

proceeds of which, according to petitioner, were used to finance

the costs of the first phase of construction and acquisition in

the Geysers Alternative.    Petitioner proposes to issue additional

bonds of $140 million to finance anticipated costs of completing

the project and expects to use $31 million of the issue to refund

the taxable bonds on a tax-exempt basis.

                              Discussion

A.   Introduction

     Gross income includes all income from whatever source

derived including interest.    Sec. 61(a)(4).   Under section

103(a), gross income does not include interest on any State or

local bond.    However, section 103(a) does not apply to “Any
                                - 10 -

private activity bond which is not a qualified bond (within the

meaning of section 141).”    Sec. 103(b)(1).    We must determine in

the instant case whether the bonds that petitioner proposes to

issue are private activity bonds.11      The parties stipulated that

the bonds will not be qualified bonds.      See sec. 141(e).

     The term “private activity bond” means any bond that is part

of an issue which meets:     (1) The private business use test of

section 141(b)(1) and the private security or payment test of

section 141(b)(2), or (2) which meets the private loan financing

test of section 141(c).     Sec. 141(a).   The parties agree that the

only issue in the instant case is whether the proposed bonds meet

the private business use test and the private security or payment

test (collectively the private business tests).      If the private

business tests are met, the bonds are private activity bonds.

See sec. 141(a)(1); City of New York v. Commissioner, 103 T.C.

     11
      Under sec. 7478, the Tax Court shall have jurisdiction, in
a case of actual controversy involving a determination by the
Secretary, to make a declaration whether interest on proposed
bonds will be excludable from gross income under sec. 103(a).
The burden of proof is on petitioner as to the grounds set forth
in respondent’s notice of determination and is on respondent as
to any ground upon which he relies and which is not stated in the
notice of determination. Rule 217(c)(2)(A) and (B); City of New
York v. Commissioner, 103 T.C. 481, 482 (1994), affd. 70 F.3d 142
(D.C. Cir. 1995). Our decision in this case is based upon the
administrative record and the stipulation of facts. Rule 217(a);
City of New York v. Commissioner, supra at 482. We assume that
the facts represented in the administrative record and in the
stipulations are true. Rule 217(b)(1); City of New York v.
Commissioner, supra at 482.
                               - 11 -

481, 498 (1994), affd. 70 F.3d 142 (D.C. Cir. 1995); sec. 1.141-

2(c), Income Tax Regs.12

       Section 141(b)(1) provides that an issue meets the “private

business use test” if more than 10 percent of the proceeds of the

issue are to be used for any private business use.     “Private

business use” means use (directly or indirectly) in a trade or

business carried on by any person other than a governmental unit.

The use of the bond proceeds by all nongovernmental persons is

aggregated to determine whether the private business use test is

met.    Sec. 1.141-3(a)(3), Income Tax Regs.   However, use as a

member of the general public is not taken into account.13      Sec.

141(b)(6)(A).   For purposes of this test, the use of financed

property is treated as the direct use of proceeds.    Sec. 1.141-

3(a)(1), Income Tax Regs.   Both actual and beneficial use by a

nongovernmental person may be treated as private business use.

Sec. 1.141-3(b)(1), Income Tax Regs.    Any use other than a

private business use is considered a government use.    Sec.

141(b)(7).

       12
      Bonds are private activity bonds if the issuer reasonably
expects, as of the issue date, that the bonds will meet the
private business tests. Sec. 1.141-2(d)(1), Income Tax Regs.
This inquiry takes into account reasonable expectations about
events and actions over the entire stated term of an issue. Sec.
1.141-2(d)(2), Income Tax Regs.
       13
      Use of financed property by the general public does not
prevent bond proceeds from being used for a private business use
because of other use. Sec. 1.141-3(c)(4), Income Tax Regs.
                               - 12 -

     The “private security or payment test” of section 141(b)(2)

relates to the nature of the security for, and the source of, the

payment of debt service on a bond issue.   Sec. 1.141-4(a), Income

Tax Regs.   This test is met if the payment of the principal of,

or the interest on, more than 10 percent of the proceeds of the

bond issue is directly or indirectly:   (1) Secured by any

interest in property used or to be used for a private business

use, or payments in respect of such property, or (2) to be

derived from payments (whether or not to the issuer) in respect

of property, or borrowed money, used or to be used for a private

business use.   Sec. 141(b)(2).14

     The regulations under section 141 provide special rules to

determine whether arrangements for the purchase of output from an

“output facility” cause an issue of bonds to meet the private

business tests.   Sec. 1.141-7(a), Income Tax Regs.15   The term

     14
      Payments taken into account as private payments and
payments or property taken into account as private security are
aggregated. Sec. 1.141-4(a)(2), Income Tax Regs. However, the
same payments are not taken into account as both private security
and private payments. Id.
     15
      The parties’ arguments on brief cite the temporary
regulations published on Jan. 18, 2001 (66 Fed. Reg. 4661), and
effective Jan. 19, 2001. After the filing of briefs in this
case, final output facility regulations were promulgated and are
generally effective with respect to bonds sold on or after Nov.
22, 2002. See sec. 1.141-15(f)(1), Income Tax Regs. The
provisions in the temporary regulations that the parties rely
upon and the provisions in the final regulations do not differ in
any material respect. For convenience, we cite the final
regulations in this opinion.
                              - 13 -

“output facility” is defined as “electric and gas generation,

transmission, distribution, and related facilities, and water

collection, storage, and distribution facilities.”   Sec. 1.141-

1(b), Income Tax Regs.   If the output facility regulations apply,

any output contract must be analyzed under section 1.141-7(c),

Income Tax Regs., which identifies those contracts that have the

effect of transferring substantial benefits of owning the bond-

financed facility and substantial burdens of paying the debt

service on bonds used to finance the facility (the benefits and

burdens test).   The general regulations under section 141(b)(1)

and (2), see secs. 1.141-3 and 1.141-4, Income Tax Regs., then

apply to determine whether other types of arrangements for use of

an output facility cause an issue to meet the private business

tests, sec. 1.141-7(a), Income Tax Regs.

B.   Private Business Tests

     We must decide whether the proposed bonds meet the private

business use test of section 141(b)(1).    If that test is met, we

must then decide whether the proposed bonds meet the private

payment or security test of section 141(b)(2).   Our primary focus

is on whether Company’s arrangement with petitioner results in a
                              - 14 -

private business use of the financed pipeline.16   Our resolution

of the issues presented represents a matter of first impression.

     1.   Arguments of the Parties

     Respondent determined that petitioner’s arrangement with

Company conveys priority rights to the capacity of the pipeline

and results in private business use of more than 10 percent of

the bond proceeds under section 141(b)(1).   Respondent also

determined that payments received from the sewage ratepayers are

private payments that represent more than 10 percent of the debt

service on the bonds under section 141(b)(2).

     Petitioner argues that the only purpose for constructing the

pipeline is the governmental purpose of sewage disposal.   It

contends that the arrangement with Company does not involve any

use by Company of the financed pipeline and that Company uses

only the wastewater that is disposed of through that pipeline.

Petitioner contends that Company’s use of the wastewater begins

only when the disposal function of the pipeline is completed and

Company takes responsibility for the waste byproduct.   Petitioner

argues, in the alternative, that, if Company’s arrangement is

     16
      Respondent addresses his determination and his contentions
on brief to Company’s arrangement with petitioner. He does not
rely on the arrangements with the irrigators. Payments from the
irrigators will not exceed 5 percent of the debt service on the
proposed bonds. Further, as we discuss below, the sewage
ratepayers use the pipeline as members of the general public.
Therefore, their use cannot cause the pipeline to be private
business use property.
                              - 15 -

determined to be a “use” of the pipeline:   (1) The use is

incidental to petitioner’s governmental use and is not a special

legal entitlement or special economic benefit, see sec. 1.141-

3(b)(7)(i) and (ii), Income Tax Regs., that results in private

business use; or (2) Company’s arrangement should be analyzed

under the output facility regulations as an output contract.

     With respect to the application of the output facility

regulations, petitioner argues that the financed pipeline is an

output facility.   Petitioner contends that the pipeline is a

water facility since it distributes wastewater to Company and the

irrigators.   Accordingly, petitioner argues that Company’s

arrangement with petitioner should be analyzed under the output

facility regulations.   Petitioner contends that the arrangement

with Company will not have the effect of transferring the

substantial burdens of paying debt service on the proposed bonds

since Company pays nothing for the wastewater.

     Respondent determined that the bond-financed pipeline is “an

integral part of the City’s sewage system” and is not a water

facility and that the term “output facility” does not include

“facilities for the disposal of treated wastewater.”   He agrees

with petitioner’s primary contention (in the context of the

private business use test) that the pipeline carries out the

sewage function of petitioner’s sewage system, it provides for

the final disposal of wastewater, it was not built to provide
                                - 16 -

water to Company, and the wastewater is merely a byproduct of the

sewage system.

       2.   Sewage Ratepayers

       We first decide whether the sewage ratepayers use the

pipeline as members of the general public, since this

determination is relevant in deciding whether the private

business tests are met.    Under section 141(b)(6)(A), use as a

member of the general public is not considered a private business

use.    Use of financed property by nongovernmental persons in

their trades or businesses is treated as general public use only

if the property is intended to be available, and in fact is

reasonably available, for use on the same basis by natural

persons not engaged in a trade or business.    Sec. 1.141-3(c)(1),

Income Tax Regs.

       Petitioner argues that the use by the sewage ratepayers

involves general public use, that their use is excepted from the

definition of private business use, and that such use is not

taken into account for purposes of section 141(b)(1).    Respondent

made no determination as to whether the use by the sewage

ratepayers represents general public use.    Further, on brief,

respondent states that he has never considered whether the use by

the sewage ratepayers involves general public use, because

whether those ratepayers are using the pipeline as members of the
                                  - 17 -

general public has no bearing on Company’s private business use

of that property.

       The sewage ratepayers’ use of the pipeline is based on

removing and ultimately disposing of their sewage and is also

based on their residence within the service area of the sewage

system.     There are no specially negotiated rate arrangements with

the sewage ratepayers for the disposal of their sewage.        See sec.

1.141-3(c)(2), Income Tax Regs.      Ordinances set uniform and

standardized sewer rates and connection fees for all users in the

service area of the sewage system.         The sewage disposal functions

of petitioner’s sewage system are available for general public

use.    We hold that the sewage ratepayers’ use of the pipeline

constitutes general public use.

       3.   Use of the Pipeline

       Respondent’s determination considered three users and two

different uses of the financed pipeline:

       The City Project is used by Company, the irrigators,
       and the ratepayers. Use of the City Project by the
       ratepayers is based on removing and ultimately
       disposing of their sewage. In contrast, use of the
       City Project by the Company and the irrigators is based
       on supplying the wastewater for use in the geyser field
       or on irrigable property.

He relies solely on Company’s purported use of the financed

pipeline and concludes that such use is a private business use of

more than 10 percent of the proceeds of the bond issue.        For the

reasons stated below, we disagree.
                              - 18 -

     First, we cannot agree that Company’s arrangement to receive

and to dispose of wastewater represents a private business use of

the financed pipeline.   It is respondent’s position in the

context of the output facility regulations that the pipeline’s

purpose is the disposal of wastewater, that it is an integral

part of petitioner’s sewage facilities, and that it is not a

facility which distributes water.    Indeed, in respondent’s reply

brief at 32, he states that “the Contract with the Company is not

an arrangement for the purchase of output, but rather was entered

for the purpose of disposing of the Wastewater.”     Also, in his

reply brief at 35 n.12, he states that “Rather than meeting the

definition of an output facility, the Pipeline Project may meet

the definition of a sewage facility [in section 142(a)(5) and

section 1.142(a)(5)-1(a)(iv), Income Tax Regs.] in that it is

property used for the collection, storage, use, processing, or

final disposal of wastewater.”   If the purpose of the pipeline is

waste removal and if it is a sewage facility that is used for the

disposal of wastewater, Company’s use of the wastewater would

begin after the pipeline’s sewage disposal purpose was completed.

     The only use involved in Company’s arrangement with

petitioner is the use of a set amount of wastewater from the

pipeline.   However, the wastewater is not financed property, and

respondent agrees that the wastewater is merely a waste byproduct

of petitioner’s sewage facilities.     Company’s use of the
                                - 19 -

wastewater begins after the pipeline’s disposal process is

complete.   Disposal of wastewater is petitioner’s only purpose

for constructing the pipeline.    We cannot agree that Company’s

use of what respondent terms “Wastewater”, and suggests is waste,

involves a use of the financed pipeline when petitioner’s sole

purpose for constructing the pipeline was to dispose of the

wastewater.   Company simply provides petitioner with a place in

which to dispose of a certain amount of wastewater in an

environmentally acceptable manner and, in turn, gets rights to

that wastewater.   In the circumstances of this case, Company’s

role in the disposal of the wastewater does not translate into a

use of the sewage facilities.

     Petitioner contends that, regardless of whether Company’s

use of the wastewater can be construed semantically as some use

of the pipeline, any such use of the pipeline is not a private

business use because taking the wastewater from the pipeline is

incidental to the governmental sewage treatment and disposal

purpose of that facility.17   Petitioner relies upon the following

     17
      Petitioner claims that from its perspective, “it is
irrelevant who takes the Treated Water and what they do with it
so long as the Treated Water is used in an environmentally sound
manner in accordance with applicable law and relevant public
policy.” Petitioner adds that if it could accomplish its
governmental purpose of sewage treatment and disposal by simply
emptying the wastewater into a lake or pit at the top of the
mountain, the cost of the pipeline would be the same and the
sewage ratepayers would still be paying increased rates for the
disposal of the wastewater.
                             - 20 -

statements in the Staff of Joint Comm. on Taxation, General

Explanation of the Tax Reform Act of 1986, at 1152 (J. Comm.

Print 1987), which discuss the reasons for the enactment of the

private business use test:

     Congress believed that * * * [the] diversion of
     governmental bond proceeds to nongovernmental users
     should be limited, but without setting the threshold
     amount so low that de minimis or incidental usage of
     government facilities and services by private users
     might cause interest on an issue to be taxable.
     [Emphasis added.]

     In response to petitioner’s contentions respondent argues

that “A legitimate governmental purpose cannot negate

impermissible private business use.”    He suggests that uses of a

bond-financed facility that are incidental to its governmental

purpose are taken into account under the private business use

test and that neither the Code nor the regulations provides a

general exception for incidental use.   He argues that the

references to the terms “incidental” and “de minimis” in the

General Explanation, which petitioner relies upon, “simply refer

to amounts of private business use that fall below the statutory

threshold established by Congress”; i.e., private business use

which is less than 10 percent of the proceeds of an issue of

bonds.

     First, we agree with respondent that neither the Code nor

the regulations provide a general exception for incidental use of

proceeds or financed property, except for the 10-percent
                               - 21 -

statutory threshold and the specific exceptions under the

regulations.18   Indeed, in the paragraph following the language

that petitioner relies upon in the General Explanation, the Staff

of the Joint Committee states at 1152:

          “To accomplish this, the Act generally defines as
     a private activity (i.e., nongovernmental) bond any
     bond of which more than 10 percent of the proceeds is
     to be used in a trade or business of any person or
     persons other than a governmental unit”. [Emphasis
     added.]

The statute, as finally enacted, demonstrates that the intended

exception of de minimis and incidental usage was accomplished, at

least in part, with the implementation of the 10-percent

threshold.19   Nevertheless, this does not indicate, as respondent

     18
      See sec. 1.141-3(b)(4)(iii)(A), Income Tax Regs., which
excepts arrangements from the definition of a management contract
if they are “solely incidental to the primary governmental
function or functions of a financed facility”; sec. 1.141-
3(d)(2), Income Tax Regs., which excepts use incidental to
financing arrangements; and sec. 1.141-3(d)(5), Income Tax Regs.,
which provides that incidental uses of a financed facility are
disregarded to the extent that those uses do not exceed 2.5
percent of the proceeds used to finance the facility.
     19
      Sec. 103(b)(2)(A) of the 1954 Code employed a trade or
business test similar to the private business use test in sec.
141(b)(1). That provision prohibited private business use
involving a “major portion” of bond proceeds. Regulations under
that section provided that use of more than 25 percent of bond
proceeds represented use of a “major portion”. Sec. 1.103-
7(b)(3)(iii), Income Tax Regs., 37 Fed. Reg. 15487 (Aug. 3,
1972). The Senate amendment preceding the enactment of the Tax
Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, proposed to
amend sec. 103(b)(2)(A) to incorporate this 25-percent threshold.
However, the 10-percent threshold was ultimately adopted. H.
Conf. Rept. 99-841 (Vol. II), at II-687 (1986), 1986-3 C.B. (Vol.
4) 1, 687.
                               - 22 -

suggests, that the characterization of use as incidental to the

overall governmental purpose of a financed facility has no

relevance.   On the contrary, we believe this characterization has

relevance not only in determining whether a particular

arrangement or special economic benefit constitutes private

business use, but also in determining whether such a use of

proceeds or financed property exceeds the 10-percent threshold.

     The regulations provide a list of the circumstances under

which a nongovernmental person is treated as a private business

user of proceeds and financed property.    The list includes

ownership, leases, management contracts, output contracts, and

research agreements.   See sec. 1.141-3(b)(2) through (6), Income

Tax Regs.    The regulations also identify a catch-all category:

“Any other arrangement that conveys special legal entitlements

for beneficial use of bond proceeds or of financed property that

are comparable to the special legal entitlements” listed above.

Sec. 1.141-3(b)(7)(i), Income Tax Regs.

     Respondent determined that Company’s reservation of a

certain capacity of wastewater from the pipeline is a special

legal entitlement for the use of that facility.    He relies on

section 1.141-3(b)(7)(i), Income Tax Regs., and contends that the

priority rights that Company has under its contract with

petitioner are comparable to those arrangements listed in the

regulations.   Specifically, he relies on the example contained in
                               - 23 -

the flush language of section 1.141-3(b)(7)(i), Income Tax Regs.,

which provides that “an arrangement that conveys priority rights

to the use or capacity of a facility generally results in private

business use.”

     Petitioner argues that its contract with Company does not

fall into any of the categories of special legal entitlements

listed in section 1.141-3(b)(2) through (6), Income Tax Regs.

Further, petitioner contends that this contract is not comparable

to any of those arrangements for purposes of section 1.141-

3(b)(7)(i), Income Tax Regs., except output contracts.   If the

arrangement is comparable to an output contract, then petitioner

argues that the output facility regulations should apply.     We

agree with petitioner.

     Company does not have any rights which involve, or are

comparable to, the ownership, leasing, or management of financed

property.20   Company’s arrangement provides only rights to

receive the wastewater that is disposed of through the pipeline.

The only arrangement, of those listed in the regulations, to

which we might conceivably view Company’s rights to be comparable

     20
      Par. (b)(2) of sec. 1.141-3, Income Tax Regs., targets
ownership of financed property; par. (b)(3) targets leases of
financed property; par. (b)(4) targets management contracts for
services involving all, a portion of, or any function of, a
facility; par. (b)(6) targets research agreements provided the
nongovernmental sponsor of the research is treated as the lessee
or owner of the financed property for Federal income tax
purposes.
                               - 24 -

is an output contract.   See sec. 1.141-3(b)(5), Income Tax Regs.

However, respondent determined that Company’s contract with

petitioner is not an output contract, and the pipeline is not an

output facility.   Indeed, respondent argues on brief that “The

Contract with the Company is not an arrangement for the purchase

of output, but rather was entered for the purpose of disposing

[of] the Wastewater.”    Given respondent’s position and his

agreement that the pipeline is a sewage facility, we cannot agree

that Company’s rights are comparable to an output contract or any

of the arrangements listed in the regulations.    We cannot agree

that Company has any special legal entitlements with respect to

the financed pipeline.   Company simply receives the waste product

that petitioner disposes of through that facility.

     Respondent also argues for the first time on brief that the

private business use test is met because the facts and

circumstances establish that Company receives a special economic

benefit with respect to the financed pipeline.    In most cases,

the private business use test is met only if a nongovernmental

person has special legal entitlements to use the financed

property under an arrangement with the issuer.    Sec. 1.141-

3(b)(1), Income Tax Regs.    However, section 1.141-3(b)(7)(ii),

Income Tax Regs., provides a special rule for facilities that are

not used by the general public:

          (ii) Special rule for facilities not used by the
     general public. In the case of financed property that
                              - 25 -

     is not available for use by the general public (within
     the meaning of paragraph (c) of this section), private
     business use may be established solely on the basis of
     a special economic benefit to one or more
     nongovernmental persons, even if those nongovernmental
     persons have no special legal entitlements to use of
     the property. In determining whether special economic
     benefit gives rise to private business use it is
     necessary to consider all of the facts and
     circumstances, including one or more of the following
     factors--

               (A) Whether the financed property is
          functionally related or physically proximate to
          property used in the trade or business of a
          nongovernmental person;

               (B) Whether only a small number of
          nongovernmental persons receive the special
          economic benefit; and

               (C) Whether the cost of the financed
          property is treated as depreciable by any
          nongovernmental person.

Respondent contends that this special rule is met in this case

because “the Pipeline Project is not available for use on the

same basis by persons not engaged in a trade or business.     Treas.

Reg. § 1.141-3(c)(1).”   We disagree.

     The pipeline is available for use by members of the general

public.   The pipeline is an integral part of petitioner’s sewage

system.   The sewage ratepayers use the sewage system, including

the pipeline, as members of the general public.   They use that

system to dispose of their sewage, and they pay what the record

reflects to be uniform and standardized rates set by ordinance.

There are no specially negotiated rate arrangements, and all
                              - 26 -

users of the pipeline for sewage disposal appear to use that

facility on a generally equivalent basis.

     Respondent seems to suggest that we focus on Company’s

particular use, i.e., its use of the wastewater from the

pipeline, and whether members of the general public use the

wastewater on the same basis as Company.    We do not believe that

is the appropriate inquiry under section 1.141-3(b)(7)(ii),

Income Tax Regs.   This special rule focuses on whether the

financed pipeline is available for use by the general public.    We

conclude that it is since the sewage ratepayers’ sewage disposal

use is as members of the general public.    Their use is

unobstructed by any incidental use and rights that Company may

have to the wastewater following its disposal through the

pipeline.   Accordingly, section 1.141-3(b)(7)(ii), Income Tax

Regs., does not apply, and the special economic benefit that

Company receives from the pipeline is not sufficient alone to

give rise to a private business use.

     Even if we were to assume that petitioner’s arrangement with

Company is a private business use of the pipeline, respondent’s

determination raises significant questions as to whether such use

exceeds 10 percent of the bond proceeds.    Respondent determined:

          In this case, one requirement imposed by Company
     is that approximately C gallons of wastewater be
     delivered each day to the geyser field during the term
     of the Contract. This represents a reservation of
     about 27% of the capacity of the Multi-Use Pipeline and
     nearly 100% of the Geyser Field Pipeline. This special
                              - 27 -

     legal entitlement of Company, a nongovernmental person,
     causes City Project to be privately used in the trade
     or business of Company. Because more than 10% of the
     Bond proceeds will be used by a nongovernmental person
     in its trade or business, the private business use test
     of § 141(b)(1) will be met if the Bond proceeds are
     used as proposed.

     Section 141(b)(1), the regulations thereunder, and the

legislative history indicate that only private business use,

alone or in the aggregate, which exceeds 10 percent of the

proceeds of the bond issue causes the private business use test

to be met.   It is clear that section 141(b)(1) requires a

quantification or a valuation of the private business use(s) for

purposes of determining whether such use exceeds this threshold.

     The regulations provide a methodology for measuring private

business use of financed property.     The amount of private

business use is determined according to the average percentage of

private business use of financed property during the measurement

period.   Sec. 1.141-3(g)(1), Income Tax Regs.    In general, the

measurement period begins on the later of the issue date of the

bond issue or the date the property is placed in service and ends

on the earlier of the last date of the reasonably expected

economic life of the property or the latest maturity date of any

bond of the issue financing the property.     Sec. 1.141-3(g)(2)(i),

Income Tax Regs.   The average percentage of private business use

is the average of the percentage of private business use during
                                  - 28 -

the 1-year periods within the measurement period.      Sec. 1.141-

3(g)(3), Income Tax Regs.

       In general, the percentage of private business use of

property for any 1-year period is the average private business

use during that year.     Sec. 1.141-3(g)(4)(i), Income Tax Regs.

This average is determined by comparing the amount of private

business use and use that is not private business use (government

use) during that year.     Id.    In the case of a facility in which

actual government use and private business use occur at different

times, the average amount of private business use generally is

based on the amount of time that the facility is used for private

business use as a percentage of the total time for all actual

use.     Sec. 1.141-3(g)(4)(ii), Income Tax Regs.   In the case of a

facility in which government use and private business use occur

simultaneously, the entire facility is generally treated as

having private business use.      Sec. 1.141-3(g)(4)(iii), Income Tax

Regs.     If, however, there is also private business use and actual

government use on the same basis, the average amount of private

business use may be determined on a reasonable basis that

properly reflects the proportionate benefit to be derived by the

various users of the facility (for example, reasonably expected

fair market value of use).       Id.

        Respondent fails to explain in his determination how a

reservation of a certain capacity of wastewater disposed of
                                - 29 -

through the pipeline translates into a use of more than 10

percent of the bond proceeds.     However, on brief, he seeks to

explain his position.   He contends that petitioner’s governmental

use and Company’s purported private use of the pipeline occur

simultaneously.   Accordingly, he claims that the entire pipeline

is treated as used in a private trade or business under section

1.141-3(g)(4)(iii), Income Tax Regs.     We disagree.

     First, even if we were to assume that Company uses the

pipeline, we cannot agree that petitioner’s governmental use and

Company’s private use would be simultaneous.     Petitioner uses the

pipeline to dispose of the wastewater it generates as a byproduct

of its sewage system.   Its use commences at its existing sewage

facilities and ends at the point-of-delivery connection.

Company, on the other hand, has agreed to assist petitioner in

disposing of a set amount of the wastewater.     In exchange,

Company will have rights to use that amount of wastewater at the

point-of-delivery connection.     Only then will Company commence

its use of the wastewater.   We cannot agree that these

circumstances establish a simultaneous use.     Any use by Company

of the pipeline is incidental and does not occur at the same time

as petitioner’s disposal use.21

     21
      If we were to characterize the pipeline in a different
manner than the way respondent characterized that facility in the
context of the output facility regulations, we might characterize
the financed pipeline as performing a dual function. It disposes
                                                   (continued...)
                              - 30 -

     Respondent’s attempts to quantify or value Company’s

purported use of the pipeline in terms of a reservation of the

capacity of the pipeline are unavailing.   We cannot agree with

respondent that his analysis represents a rational measurement of

Company’s alleged use of the pipeline.   In his attempt to

quantify or value Company’s alleged use of the pipeline,

respondent fails to account for the sewage ratepayers’ use of the

pipeline to dispose of their sewage.   Nevertheless, in other

parts of his determination he relies upon the sewage ratepayers’

use of the pipeline.   Further, respondent’s attempt at measuring

Company’s use is not reconcilable with his characterization of

the pipeline as a sewage facility which was constructed for the

purpose of wastewater disposal.   His measurement fails to account

for the presence of this governmental purpose, and, instead,

relies solely on what he views as a reservation of the capacity

of the pipeline.   We cannot agree that a reservation of what

respondent agrees is a waste byproduct of petitioner’s sewage

     21
      (...continued)
of the wastewater that is produced as part of petitioner’s sewage
system, and it distributes water to Company for use in its
electricity operations. However, that is not the
characterization that respondent advocates in this case. On the
contrary, he suggests that the pipeline’s purpose is waste
removal and that it does not perform a water distribution
function.
                              - 31 -

facilities equates with a use of 27 to 100 percent of the

pipeline facility which disposes of such waste.22

     Given the circumstances of this case and the arguments of

the parties, the more appropriate view is that Company does not

use the financed pipeline in any quantifiable amount, and,

certainly, not in an amount in excess of 10 percent of the bond

proceeds.   In support of this view, we note that Company pays

nothing to petitioner for its purported use of the financed

pipeline, or, for that matter, the wastewater.   Company simply

agrees to dispose of the wastewater that it receives, and in

exchange it is given rights to use the water in its electricity

operations.   The sewage ratepayers, on the other hand, will pay

fees for the disposal of their sewage which will amount to at

least 95 percent of the debt service on the bonds used to finance

the pipeline.   This, in our view, indicates that at least 95

percent of the financed pipeline will be used for sewage

disposal.   This represents a more accurate reflection of the use

of the pipeline than respondent’s determination that more than 10

percent of the pipeline will be used by Company.

     22
      Also, we note that sec. 1.141-3(d)(5), Income Tax Regs.,
excepts incidental uses of a financed facility which do not
exceed 2.5 percent of the proceeds used to finance the facility.
In responding to the potential application of that provision,
respondent states without explanation that the latter provision
does not apply “in light of the extensive rights the Company has
with respect to the capacity of the Pipeline Project.”
                               - 32 -

     We hold that the private business use test is not met.

Accordingly, the proposed bonds will not be private activity

bonds.23   Interest on those bonds will be excludable from gross

income under section 103(a).

                                              Decision will be

                                         entered for petitioner.

     23
      A bond issue meets the private business tests of sec.
141(b) if it meets both the private business use test and the
private security or payment test. City of New York v.
Commissioner, 103 T.C. at 498. Because the bond issue in the
instant case fails to meet the private business use test, it is
unnecessary for us to discuss whether the private security or
payment test is met.