Court Opinion

ID: 4472709
Source: CourtListenerOpinion
Date Created: 2020-01-14 19:34:52.056036+00
Date Added: 2024-06-11T11:51:20.498029
License: Public Domain

Beghe, J., concurring: I agree with and have joined the majority opinion that the bonds in question were taxable arbitrage bonds within the meaning of section 148(f): the bond proceeds were used to purchase investments that were not acquired to carry out the governmental purpose; .those investments produced excess earnings under section 148(f)(2); and the issuer has failed to rebate the amount of the excess earnings to the United States. In enacting section 148(f) of the 1986 Code, Congress repudiated the holding of Washington v. Commissioner, 77 T.C. 656 (1981), affd. 692 F.2d 128 (D.C. Cir. 1982), and thereby made clear that “amounts earned” on nonpurpose investments are not limited to amounts that directly inure to the issuer: they also include excess earnings that enable more than a de minimis part of the bond proceeds to be diverted to pay underwriters, bond and tax counsel, and other service providers. See S. Rept. 99-313, at 828, 845 (1985), 1986-3 C.B. (Vol. 3) 1, 828, 845. As a result, the interest on the bonds ostensibly issued by the Riverside Housing Authority was not excludable from the income of the bondholders under section 103. I write separately to focus on three additional grounds, the first two of which were also advanced by respondent, for holding taxable the bonds in this case (and the bonds in other pending cases). I. I believe that the bonds in question were arbitrage bonds on the date of issuance under section 103(d), as enacted by the Tax Reform Act of 1969, Pub. L. 91-172, sec. 601(a), 83 Stat. 487, 656. Contrary to Judge Jacobs, dissenting op. p. 301, I believe that the Riverside Housing Authority failed to show, as of the date of issuance in February 1986, that it did not reasonably' expect that the proceeds would be invested in higher yield obligations. On the subject of reasonable expectations, petitioners are off base in arguing that, if our decision goes against them, the standard of care required of State and local issuers will have been retroactively made higher than it was or should have been at the time the deals were done. I agree with respondent that the issuer's standard of care set forth in section 1.148-1(b), Income Tax Regs. (the 1993 reg.), is basically no different from what was required under the regulation in effect in 1985-86, section 1.103-13(a)(2), Income Tax Regs. (the 1979 reg.). Even if there may now be a higher level of consciousness among State and local bond issuers and their counsel about the levels' of due diligence required, reasonableness is an objective and normative standard. By any such standard, the Riverside Housing Authority and its counsel were egregiously and inexcusably lax in failing to monitor the Whitewater and Ironwood transactions and in allowing the messes to happen.1  f — I I — I In addition to being arbitrage bonds, the bonds were also taxable industrial development bonds under section 103(b)(1) of the 1954 Code. Petitioners have conceded that the Whitewater and Ironwood bonds were industrial development bonds within the meaning of section 103(b)(2) of the 1954 Code, on the ground that the proceeds of both issues were “to be used directly ... in any trade or business carried on by any person who is not an exempt person.” The only dispute on this issue is whether the bonds qualified under section 103(b)(4)(A), which provides that an industrial development bond will not be taxable under section 103(b)(1) if it is part of an issue “substantially all of the proceeds of which are to be used to provide” (emphasis added) various exempt facilities. The question is the meaning of the phrase “are to be used”. Both the Whitewater and the Ironwood issues were industrial development bonds under section 103(b)(2) because the proceeds were to be lent to private, for-profit developers for the purpose of constructing apartment projects to be used in a private trade or business, and repayment of the bonds was to be secured, directly or indirectly, by the apartment projects and the income they produced. Although the documents provided that the Whitewater bonds and the Ironwood bonds were to fund the construction of residential rental properties that would meet the 20 percent low-income set-aside requirements of section 103(b)(4)(A)(ii),2 what is in dispute is whether substantially all the proceeds of the Whitewater and Ironwood bonds were to be used for residential rental property. While the phrase in section 103(b)(4) is “are to be used”, the statutory sentence does not stop there but sets forth low-income residence requirements that must be met “at all times during the qualified project period”. Thus, compliance requires examination of actual events occurring after the issue date. It would be illogical to suggest that expectations controlled until the units were occupied, and that thereafter actual events would control. Such a reading would put a party that never tried to build the residential rental project in a better position than a party who built the project but inadvertently failed to satisfy the low-income requirements. Under section 1.103-8(b)(6)(ii) and (iii), Income Tax Regs, (the 1979 reg.), issuers are permitted a reasonable period of time to correct noncompliance. Section 1.103-8(b)(6)(i) and (9), Income Tax Regs, (the 1979 reg.), makes clear that satisfaction of the residential rental property exception of section 103(b)(4)(A) requires more than just a good faith hope or assumption that the proceeds of a bond issue will be properly applied. Section 1.103-8(b)(6)(i), Income Tax Regs, (the 1979 reg.), provides that a post-issuance nonconforming change will vitiate the exemption — retroactive to the original issue date — unless corrected within a reasonable time. Examples (4) and (5) of section 1.103-8(b)(9), Income Tax Regs, (the 1979 reg.), illustrate this rule. In example (5), 5 years after constructing a qualified residential rental project, corporation P, the developer and owner, converted 80 percent of the units into nonqualifying condominium units and repaid the loan to State X, the bond issuer, which in turn redeemed the bonds. The example concludes that the bonds were not used to provide residential rental housing within the meaning of section 103(b)(4)(A). In example (4), there is a similar disqualifying event, the failure of the issuer, county Z, to enforce the 20 percent requirement. As a result, the bonds are classified as nonexempt industrial development bonds, retroactive to the date of issuance.3  Petitioners would construe examples (4) and (5) as inapplicable because the disqualifying actions by the issuers or developers are “volitional”. I believe that the examples do apply to the case at hand because in each of them — as in the case at hand — the governmental issuer fails to enforce the statutory requirements that are violated by the developer-owner of the project. The Whitewater project was never built; no units were ever built for rental to low- and moderate-income tenants or to anyone else. Indeed, the Whitewater project could never have been built with bond proceeds because, on February 20, 1986, $16,110,817.98 (91 percent) of the $17,778,146.53 of the Whitewater bond proceeds was invested in a GIC that had the same maturity as the bonds. The appropriate test is whether the issuer reasonably expects, at the time the bonds are issued, that substantially all of the bond proceeds will be devoted to the exempt facility and the issuer thereafter takes steps to ensure that the bond proceeds are used in a manner consistent with those expectations. In addition, in conduit financing transactions such as Whitewater and Ironwood, the expectations and subsequent conduct of the conduit borrowers, the Whitewater and Ironwood partnerships, must also be considered. Industrial development bond financing by definition contemplates significant involvement by nongovernmental parties. Interest on industrial development bonds is exempt from taxation only if the exempt facility rules are met. Because the exempt facility rules require proceeds to be spent in a specified manner and because a conduit borrower is a necessary party to an exempt facility financing, testing compliance with the exempt facility rules in the use at hand requires consideration of the actions of the conduit borrowers, the Whitewater and Ironwood partnerships. Construing section 103(b)(4) to require subsequent conduct in furtherance of the original reasonable expectations is consistent with the statutory language and furthers the statutory purpose. Section 103(b)(4) contains set-aside requirements that must be met throughout the “qualified project period” (a period that begins on the first day in which 10 percent of the project units are occupied). If those set-aside requirements are not met, the interest on the bonds is taxable from the date of issuance, irrespective of the reasonableness of the issuer’s expectations at the inception of the deal. Sec. 103(b)(4)(A), (12)(B). Thus, the phrase “are to be used” looks to how the bond proceeds are actually used, not just to how the proceeds were expected to be used at the time the bonds were issued. This conclusion is supported by the contrasting language of subsections (c) and (b) of section 103. Section 103(c) defines an “arbitrage bond” as a bond “the proceeds of which are reasonably expected to be used” (emphasis added) for higher yielding investments. Compare the clear command of section 103(c) to look only at expectations with the language of section 103(b), which provides how substantially all of the “proceeds of * * * [the bond issue] are to be used” (emphasis added). This difference in focus strongly suggests that Congress intended two different tests to apply and that the test in section 103(b) was intended to be more than a pure expectations test. This suggested reading of this statutory provision also prevents bizarre and inappropriate results. If only expectations on the date of issue are relevant, then an issuer who initially planned to have residential rental property built, but never took steps to assure that the housing project was constructed, would be better off under the statute than an issuer who actually caused the housing to be constructed but then inadvertently failed to satisfy the set-aside requirements. Such an anomalous result would be the product of petitioners’ interpretation of the statute. Thus, substantially all of the Whitewater bond proceeds were not “to be used” for residential rental property within the meaning of section 103(b)(4). While respondent concedes that the Ironwood project was built and provided housing for low- and moderate-income tenants, the Ironwood bonds are nevertheless not entitled to tax-exempt status under section 103(b)(4). Just like the Whitewater bonds, substantially all of the bond proceeds ($11,047,408.05 of the $12,190,843.34 or 91 percent of the proceeds) went directly into a higher yielding GIC that had the same maturity as the bonds. Because the bond proceeds were tied up in the GIC, another source of funds had to be found to pay for the project. That source turned out to be Far West Savings & Loan, which made a conventional secured construction loan of $10,300,000 to Ironwood Apartments Ltd. evidenced by a disbursement agreement, promissory note, deed of trust, and other related loan documents. Except for the relatively modest amount spent to purchase the Ironwood land, the Ironwood project was financed by a conventional mortgage loan from a conventional savings and loan, not with bond proceeds. Given the structure of the deal, it could not have been otherwise. The lion’s share of the Ironwood bond proceeds had already been invested in the Ironwood GIC. From February 20, 1986, until December 1, 1993, when the GIC paid off and the bonds were redeemed, that is where they stayed. The Riverside Housing Authority could not have reasonably expected that substantially all of the proceeds of the Whitewater and Ironwood bonds would be used to construct the projects. This is because the bond financing documents deprived it, the trustee, and the conduit borrowers (the developers) of control over the bond proceeds and allowed the bond proceeds to be diverted. Without any agreement, the Riverside Housing Authority, the trustee, and the conduit borrowers had no assurance that the bond proceeds would be used, as required by the bond indentures, to finance the multifamily housing projects. Petitioners have argued that the Riverside Housing Authority was duped, indeed that the bond proceeds were stolen, and Judge Jacobs seems to agree. It was not, however, reasonable for the Riverside Housing Authority to sponsor a financing structure that permitted it, the trustee, and the developer to lose control of the bond proceeds. Like section 103(c), section 103(b) should not be read to encourage issuers both to be ignorant of the facts prospectively and to remain ignorant and do nothing after the fact. Because the Whitewater and Ironwood bonds were not exempt industrial development bonds under section 103(b)(4), by virtue of section 103(b)(1), they were not tax-exempt bonds under section 103(a). Petitioners and Judge Jacobs, dissenting op. note 2, argue that the diversion of the bond proceeds amounted to “involuntary noncompliance” under section 1.103-8(b)(6)(iii), Income Tax Regs, (the 1979 reg.). Their argument seems to be based on the assumption or assertion that nothing could be done after the fact by the Riverside Housing Authority because the bond proceeds had flowed irrevocably to Crown Life Insurance Co., which had issued the Gic’s. Judge Jacobs states that “the bond proceeds were improperly locked into Gic’s”. Dissenting op. note 2. However, I don’t understand why the Riverside Housing Authority could not have brought a successful action to revoke the Gic’s and recover the proceeds for use as originally intended. If the funds had been unlawfully diverted, didn’t Crown Life Insurance Co. have •notice, actual or constructive, of this fact? The answer to these questions may be that the Riverside Housing Authority decided, once things started to go badly for the developer, that it would be better to leave the bond holders with the continuing better assurance that they would receive interest and principal payments, as originally scheduled, through the security of the Gic’s. Even if such had been the case, the security so created must be at the,price of the loss of the tax exemption for the interest on the bonds. I — I hH I — I Although I accept the stipulations of the parties and the findings of the trier of fact, as adopted by the majority in the case at hand, I’m impelled to raise a question that may be germane to other pending cases. If the failures in other cases of the purported government issuers to supervise the receipt and disposition of bond proceeds were as egregious as they were in the case at hand, the question that may arise in such other cases is whether the bonds were ever issued or validly issued by the local governments or authorities. In the case at hand, it might well have been concluded that the Riverside Housing Authority was so out of the loop that, under step transaction principles, the bond holders were the recipients of nothing more than the obligations of Crown Life Insurance Co. or of undivided interests in the Gic’s — taxable obligations of a private issuer — that were purchased with the bond proceeds for their benefit. The housing authority was so lax in failing to see to it that the proceeds were used for the intended purpose as to raise the question whether the housing authority actually had any such purpose, thereby calling into question the validity of its purported issuance of bonds. As the Court of Appeals for the District of Columbia Circuit said in Washington v. Commissioner, 692 F.2d at 137: Still, states and municipalities should be chary in their issuance of tax-free bonds and their subsequent reinvestment of the proceeds. It is a fundamental principle of state and municipal bond law that the issuing body must have a legitimate, independent purpose to sell debt instruments in order to raise moneys. L. Jones, THE LAW OF BONDS AND BOND SECURITIES §12 (1950). If no such purpose exists, the issuance would be violative of local law, and should not qualify for the tax exemption that Section 103 provides for validly issued municipal and state bonds. * * * The steps in the analysis would be along the following lines: 1. The bonds were sold to the public as the housing authority’s revenue bonds, based on representations that the proceeds would be used to finance construction of the housing projects; 2. because the obligations on the bonds were nonrecourse to the housing authority, the primary sources of payment of the bond obligations were to be the housing projects and the income streams that the projects were expected to generate; 3. contrary to the conception underlying a properly structured “black box” scheme,4 the proceeds of the bond offerings were irrevocably diverted from the projects on the day of issuance and what was substituted for the projects as security for the obligations to the investors were shell corporations’ letters of credit secured by the Gic’s; 4. what this means is that the so-called originator of the conduit financings, the housing authority, was eliminated from (or never even got into) the loop. The housing authority as such did not issue its own bonds. All that the so-called bonds purportedly issued by the housing authority evidenced were the interests of the bond holders in the Gic’s, which were obligations of a taxable entity, the Crown Life Insurance Co. As a result, the bonds were taxable obligations from their inception. All the woofing about reasonable expectations, monitoring actual usage, the arbitrage rebate rules, and the status of the bonds as industrial development bonds may well be subsequent questions that one need never get to under a proper tax analysis. Chabot, J., agrees with this concurring opinion.   What I have in mind here wee said by Judge Learned Hand in the landmark tort csse in which he made it clear that a normative standard of care end reasonableness-that courts are authorized to determine and impose-trumps the customary practices of a particular industry: Is it then a final answer that the business had not yet generally adopted receiving sets? There are, no doubt, cases where courts seem to make the general practice of the calling the standard of proper diligence; we have indeed given some currency to the notion ourselves. Indeed in most cases reasonable prudence is in fact common prudence; but strictly it is never its measure; a whole calling may have unduly lagged in the adoption of new and available devices. It never may set its own tests, however persuasive be its usages. Courts must in the end say what is required; there are precautions so imperative that even their universal disregard will not excuse their omission. But here there was no custom at all as to receiving sets; some had them, some did not; the most that can be argued is that they had not yet become general. Certainly in such a case we need not pause; when some have thought a device necessary, at least we may say that they were right, and the others too slack. The statute does not bear on this situation at all. It prescribes not a receiving, but a transmitting set, and for a very different purpose; to call for help, not to get news. We hold the tugs therefore because had they been properly equipped, they would have got the Arlington reports. The injury was a direct consequence of this unseaworthiness. [The T.J. Hooper v. Northern Barge Corp., 60 F.2d 737, 739 (2d Cir. 1932); citations omitted.]    Respondent concedes that the Ironwood project met the low-income set-aside requirements of sec. 103(b)(4)(A)(ii).    See also sec. 1.103-8(a)(1), Income Tax Regs, (the 1979 reg.) (“Substantially all of the proceeds of an issue of governmental obligations are used to provide an exempt facility if 90% or more of such proceeds are so used.”); H. Conf. Rept. 99-841, at 11-697 (1986), 1986-3 C.B. (Vol. 4) 1, 697 (“The conference agreement further provides that at least 95 percent of the net proceeds of each issue must be used for the exempt facility for which the bonds are issued”); Woods v. Homes & Structures, Inc., 489 F. Supp. 1270, 1292 (D. Kan. 1980) (“Although Section 103 speaks in prospective terms * * * we tend to agree with plaintiffs that the actual distribution of the proceeds will control”).    I have my doubts about the efficaciousness of the “black box” scheme, but, under the facts of the purported bond issues of the Riverside Housing Authority, that question need not detain us in other cases in which the bond proceeds were diverted in similar fashion.