ABA Tax Section Recounts History of Tax-Exempt Bonds

May 10, 2017

The Honorable John A. Koskinen
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

Re: Comments on Tax-Exemption of Interest on State and Local Bonds

Dear Commissioner Koskinen:

Enclosed please find comments on the history of tax-exemption of interest on state and local bonds (“Comments”). These Comments are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss the Comments with you or your staff if that would be helpful.

Sincerely,

William H. Caudill
Chair, Section of Taxation

Enclosure

cc:
William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service
Helen M. Hubbard, Associate Chief Counsel (Financial Institutions & Products), Internal Revenue Service
Vicky Tsilas, Branch Chief (Financial Institutions & Products), Internal Revenue Service
Thomas West, Acting Assistant Secretary (Tax Policy) and Tax Legislative Counsel, Department of the Treasury
John J. Cross, Associate Tax Legislative Counsel, Department of the Treasury

---

AMERICAN BAR ASSOCIATION
SECTION OF TAXATION

TECHNICAL COMMENTS ON THE HISTORY OF TAX-EXEMPTION OF INTEREST

These comments ("Comments") are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments was exercised by Todd L. Cooper and David J. Cholst, of the Section’s Committee on Tax-Exempt Financing (the “Committee”). Substantive contributions were made by Charles L. Almond, Jackson B. Browning, John W. Hutchinson, Evan A. Toebbe, Nancy Lashnits, and Mark O. Norell. The Comments were reviewed by Stefano Taverna, Chair of the Committee. The Comments were further reviewed by R. David Wheat, the Section’s Council Director for the Committee, Robert M. Gordon, of the Section’s Committee on Government Submissions, and Julian Y. Kim, the Section’s Vice Chair (Government Relations).

Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member of the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contacts:

Date: May 10, 2017

EXECUTIVE SUMMARY

From the beginning of the federal income tax, interest on state and local bonds has been exempt from federal income taxation. While this exemption for state and local bonds (sometimes also referred to herein as “tax-exempt bonds”) has been modified from time to time, Congress has never eliminated it. There have been many calls through the years, however, to abolish the exemption. In fact, legal commentators as far back as the 1960s referred to the debate over whether the tax exemption should be eliminated as “old and tired.” ¹ Ultimately, strong policy considerations have counseled against a wholesale elimination of the federal income tax exemption for state and local bonds. From its inception and continuing through the present, the exemption has remained a vital part of the American tax system. These Comments were produced upon the invitation of officials in the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “Service”).

Part I will discuss the origins of the exemption, including the constitutional foundation on which it originally appeared to rest. Part II will discuss the history of the exemption from 1914 through 1967, including the numerous failed attempts to repeal the exemption. Part III will begin by detailing the major shift in tax-exempt bond treatment that occurred in 1968. Part IV will then continue with a discussion of the statutory modifications Congress made from 1969 through 1987. Part V will continue with a discussion of some significant federal court decisions involving tax-exempt bonds, in particular the impact of the Supreme Court decision in South Carolina v. Baker,² which arguably limited the constitutional protections for tax exemption, along with later developments that may indicate that the Constitution limits the ability of Congress to completely eliminate the exemption. The Conclusion briefly describes some of the non-legal, economic policy and political questions that typically surface in debates about tax-exempt bonds generally.

As discussed below, even when Congress has restricted the availability of tax-exempt bonds to prevent perceived abuses or possibly to raise revenue, Congress has always retained the exemption for certain types of bond issues that have a recognized public purpose under state law. As the old saying goes, it has never thrown the baby out with the bathwater.

I. THE ORIGINS OF THE EXEMPTION: THE 1800S THROUGH 1913

The federal income tax exemption for interest on state and local bonds predates even the first Internal Revenue Code. In fact, the history of this exemption can be traced all the way back to the Supreme Court’s celebrated 1819 decision in McCulloch v. Maryland.³ The McCulloch Court held that state governments could not tax the federal government if it would interfere with the federal government’s Constitutional powers.⁴ Although McCulloch imposed Constitutional restrictions on state power to tax, it also forms the bedrock of the Constitutional argument for restricting the federal power to tax interest on state and local bonds. This is because in 1871 the Court applied McCulloch to the converse situation in Collector v. Day.⁵ In Day, the Court struck down a federal tax on the salary of a state judicial officer and held that the states and the federal government are distinct entities unable to levy taxes on each other.⁶ This constitutional doctrine became known as “intergovernmental tax immunity.”

In spite of this background, early legislative proposals for a federal income tax would have taxed interest on state and local bonds. In the late 1890s, populist demands for a federal income tax resulted in an income tax bill that was incorporated into the Tariff Act of 1894. ⁷ Out of deference to Collector v. Day, salaries for state, county, and municipal officers were exempted from the income tax. Interest on state and local bonds, however, was subject to the tax. This provision was challenged immediately in Pollock v. Farmers Loan & Trust Co., where the Supreme Court declared the tax unconstitutional.⁸ The Court found the entire income tax to be a direct tax that violated Article I, Section 2 of the Constitution because Congress did not apportion it among the states.⁹ Importantly, the Court also directly addressed Congress’ attempt to tax interest on state or local bonds. Even though a tax on state and local bond interest directly burdens the holders of the bonds, and not the state or local issuer of the bonds, the Court held that a tax on the interest on state or local bonds violated intergovernmental tax immunity because it did burden the state or local issuer by taxing the issuer’s power to borrow money.¹⁰

After the Supreme Court struck down the 1894 income tax in Pollock, a strong political movement developed for a progressive income tax. This movement culminated in a constitutional amendment to allow for an unapportioned income tax. This amendment was ratified and, in 1913, became the Sixteenth Amendment to the U.S. Constitution. This cleared the way for the Revenue Act of 1913 (“1913 Act”), which implemented the modern federal income tax. While the Sixteenth Amendment allowed Congress to impose an unapportioned income tax, the common view was that Congress still could not tax the interest on state or local bonds because such a tax would violate intergovernmental tax immunity and would therefore be unconstitutional.¹¹ The 1913 Act reflected this belief, specifically stating: “In computing the net income under this Section, there shall be excluded the interest upon the obligations of a state or any political subdivision thereof.”¹² Thus, from the very beginning, the revenue acts, which were eventually codified into the Internal Revenue Code, explicitly barred the federal government from taxing interest on state or local bonds, based on the belief that the Constitution implicitly barred it from doing so.

II. THE EXEMPTION’S STAYING POWER: 1914-1967

The argument that the tax exemption for interest on state and local bonds should be repealed for economic and equitable reasons has been around since the time the exemption was enacted in 1913. In fact, as early as 1918, when the nation was seeking revenue near the end of World War I, the House approved, but the Senate later rejected, a bill that would have ignored the intergovernmental tax immunity doctrine and taxed interest on state and local bonds.

The view that intergovernmental tax immunity flowed from the Constitution and prevented Congress from taxing state and local bond interest caused most of the early attempts to repeal the exemption to focus on amending the Constitution. The first of these amendment attempts came in 1923, when the House passed a resolution that proposed a constitutional amendment allowing interest on state and local bonds to be taxed.¹³ This resolution, however, died in the Senate.¹⁴ When tax rates fell in the mid-1920s and therefore reduced the putative cost of the exemption to the federal government, the frequency of challenges to the exemption diminished. However, when tax rates increased again in the 1930s, calls for repeal resumed. In 1933, the Senate approved a bill to tax interest on state and local bonds, but the Conference Committee dropped it.¹⁵ Between 1932 and 1937, no less than 80 resolutions for constitutional amendments were introduced in Congress to repeal the exemption.¹⁶ Not one of those resolutions was passed by Congress.

By the end of the 1930s, however, the Supreme Court began to chip away at certain aspects of intergovernmental tax immunity doctrine in decisions such as Helvering v. Gerhardt,¹⁷ which eased the prohibition in Collector v. Day and held that in certain situations the federal government could indeed tax the salaries of state officials.

As Supreme Court decisions began to cast doubt on the constitutional protection from taxation for interest on state and local bonds, Congress continued to extend statutory protection. When Congress first codified the revenue acts by adopting the Internal Revenue Code of 1939 (“1939 Code”), the explicit exemption of state and local bond interest from federal income tax was continued.¹⁸ This express codification, coupled with the Court’s erosion of the intergovernmental tax immunity doctrine, prompted opponents of the exemption to shift their focus from attempted constitutional amendments to attempted statutory change. Shortly after the 1939 Code was enacted, the Public Bond Tax Act of 1940 was introduced, providing for the taxation of both federal and state securities. This proposal was vigorously debated and subsequently defeated.¹⁹

Soon thereafter, the Revenue Bill of 1942²⁰ made its way through Congress. The version of this bill that originally passed the House would have taxed interest on state and local bonds. The House did not include an exemption in the bill because of the nation’s need for tax revenues, this time to finance America’s participation in World War II.²¹ However, the Senate amended the bill to exempt interest on state and local bonds and the exemption survived again.

After lying dormant for a few years, the tax exemption issue was revived in the late 1940s and early 1950s. In both 1949 and 1954, attempts were made to tax local housing authority bonds, but each attempt was defeated.²² In 1951, because the country was again seeking money during wartime, Congress attempted to repeal the exemption in the Revenue Act of 1951.²³ Like the numerous efforts before it, this attempt at repeal failed. When the Internal Revenue Code of 1954 (“1954 Code”) was enacted, the exemption for state and local bond interest remained intact.²⁴ The 1954 Code stated that “gross income does not include interest on . . . the obligations of a State, Territory, or a possession of the United States, [or] on any political subdivision of any of the foregoing.”²⁵

Although the exemption survived the second major iteration of the Internal Revenue Code without erosion, major changes were coming. These changes, which began in the late 1960s, ushered in decades of reforms that, without eliminating tax-exempt bonds, would adversely affect state and local governments’ ability to issue them for certain purposes and under certain circumstances. Nonetheless, the ability of states and local governments to issue tax-exempt bonds for many purposes, including public facilities and public infrastructure, remained intact and unaltered.

III. THE SHIFT IN STATE AND LOCAL BOND TREATMENT: 1968-1987

Congress began to modify the exemption in the late 1960s, and made a number of changes over the following two decades. In the 1970s interest rates began to rise, and in the early 1980s interest rates had risen to historically high levels, increasing the demand for financing at the relatively lower rates available from borrowing on a tax-exempt basis. Even as interest rates began to slowly fall, the volume of tax-exempt bonds continued to grow as the opportunity for refinancing at lower rates arose. By the mid-1980s, section 103 of the 1954 Code, which contained the exemption, had been amended many times and had grown in length and complexity, in an effort by Congress to control the increased size of the tax-exempt bond market. When the Internal Revenue Code of 1986 (the “Code”) was adopted, many of the rules in section 103 of the 1954 Code were re-codified into eleven sections (i.e., sections 103 and 141 to 150)²⁶ that dealt with the treatment of state and local bond interest.²⁷ Throughout this time, Congress focused on limiting the exemption by requiring, among other matters, that tax-exempt bonds be issued only for certain purposes, by focusing on the use of tax-exempt bonds for the benefit of certain entities or categories of individuals, by limiting the issuance of bonds that might obtain arbitrage advantages, and by imposing volume caps on certain types of tax-exempt bonds.

A. Limitation on Tax-Exempt Bonds for Private Projects

To spur economic development during the Great Depression, states had increasingly used state and local bonds to finance private business ventures. They repaid the bonds with the revenues from the private ventures. These bonds began to resemble private loans where the funds merely passed through the governmental issuer to the private venture in order to secure a tax exemption. As the practice of issuing state and local bonds for private purposes increased in popularity, Congress responded by restricting the use of tax-exempt state and local bonds for private purposes.

Under the Revenue and Expenditure Control Act of 1968 (“1968 Act”),²⁸ Congress for the first time created a distinction between state and local bonds issued for a predominantly public purpose (which remained tax-exempt) and state and local bonds issued for a private purpose (which were now subject to taxation unless they qualified for an exception as discussed below). The 1968 Act never defined a “public purpose.” Instead, it labeled certain bonds as “industrial development bonds” (“IDBs”) (now commonly referred to as private activity bonds) and said that interest on IDBs would not be tax-exempt. A state or local bond would be an IDB if it exceeded two limits. First, more than a “major portion” of the bond proceeds had to be used by a nongovernmental entity in a trade or business (the “use of proceeds test”). Second, more than a major portion of the principal and interest on the bond had to be secured by, or derived from payments in respect of, property used in a trade or business (the “security interest test”).²⁹ Under the 1968 Act, interest on a state or local bond would be subject to taxation only if it exceeded both of these limits without otherwise qualifying for an exception.

Congress recognized, however, that the IDB definition was so broad that it could cover some important activities involving a public purpose that deserved to be eligible for tax-exempt financing. Accordingly, the 1968 Act retained the tax exemption for IDBs that financed the following activities: (i) residential rental projects; (ii) sports facilities; (iii) convention or trade show facilities; (iv) airports, docks, wharves, mass commuting facilities, or parking facilities; (v) sewage or solid waste disposal facilities, or facilities for the local furnishing of electric energy or gas; (vi) air or water pollution control facilities; (vii) water furnishing facilities; and (viii) industrial park land acquisition or development.³⁰ Additionally, the 1968 Act acknowledged the viability of private purpose tax-exempt bonds as an economic development tool by allowing an exemption for “small issue IDBs” (i.e., any IDB issue of $1 million or less), which continued to receive a tax exemption if the bond proceeds were used for the acquisition, construction, or improvement of land or depreciable property.³¹ The $1 million limit could be increased to $5 million if the capital expenditures of the borrower or other “substantial user” of the project in the applicable jurisdiction over a six year period were not expected to exceed $5 million.

Thus, although Congress curbed certain perceived abuses of tax-exempt bonds issued for private purposes, it also concluded that some private projects that served an important public purpose and benefitted the community at large should continue to be eligible for tax-exempt bond financing. Although the bonds that financed these favored private activities were largely secured by private revenues and largely used for projects that were managed (and often owned) by private firms, Congress continued to exempt interest on IDBs used to finance these private activities because they were sufficiently beneficial to the public and economic growth.

The Economic Recovery Act of 1981³² expanded the list of IDBs eligible for tax-exempt financing to include mass transportation vehicles such as buses and railcars. With the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”),³³ however, Congress did limit the exemption for certain activities that, in its view, did not have a sufficiently public purpose. TEFRA eliminated the exemption for certain small issue IDBs³⁴ where more than 25 percent of the bond proceeds were used for facilities dealing with automobile sales, food or beverage services (not including grocery stores), or recreational services.³⁵ TEFRA also eliminated the ability to issue almost all bonds in “bearer” form because a determination of who owned a bearer bond could not be made until the bond was turned in for payment. In addition, the coupons (representing the interest payments) on a bearer bond could be stripped from the bond, making it more difficult to determine ownership of a bond. Congress was concerned that some of these bearer bonds were being held by individuals engaged in criminal activities, including the distribution of illegal drugs, thus allowing those individuals to “launder” or hide their illegally obtained money. TEFRA required that bonds be issued in “registered” form to qualify for a tax exemption.³⁶ Registered bonds preserve a record of the ownership of the bonds at all times, and a registered bond does not have detachable coupons. TEFRA also required that an issuer obtain public approval before issuing IDBs (by either a hearing or a voter referendum) and the filing with the Service of an information return (which is now in the 8038 series of IRS forms) for the bonds. TEFRA’s registration requirement was the subject of the Supreme Court case, South Carolina, ³⁷ which is discussed further in Part IV of this paper.

In the mid-1980s, Congress significantly changed the test for IDB status. Prior to 1984, a bond would be a taxable IDB only if a private person used more than 25% of the bond proceeds in a “trade or business.” Thus, a state or local bond would not be an IDB if the issuer lent the proceeds to individuals not engaged in a trade or business. The Deficit Reduction Act of 1984 (“1984 Act”)³⁸ changed this treatment by taxing interest on certain “consumer loan bonds.” Consumer loan bonds were defined as bonds five percent or more of the proceeds of which were used to provide loans to individuals. This would eventually become known as the “private loan” limit. As always, Congress recognized that certain types of private loan bonds could serve a public purpose. The 1984 Act therefore exempted certain types of consumer loan bonds from taxation, including qualified single family mortgage revenue bonds,³⁹ qualified veterans^- mortgage revenue bonds,⁴⁰ and student loan bonds.⁴¹

Like the 1968 Act, the Tax Reform Act of 1986 (“1986 Act”)⁴² did not define public purpose but continued to limit the private activities that could benefit from the tax exemption. Under the 1986 Act, what were previously known as IDBs would now be called “private activity bonds” (“PABs”).⁴³ The two-part “IDB test” remained in place as the test for determining if a bond was a PAB; however, the 25 percent figure used for the IDB use of proceeds and security interest tests was reduced to ten percent.⁴⁴ The 1986 Act also narrowed the list of activities that could be financed with PABs that would remain tax-exempt. Specifically, the 1986 Act narrowed the tax exemption for airports, docks, wharves, and other mass-commuting facilities and repealed altogether the exemption for sports facilities, convention or trade show facilities, parking facilities, air or water pollution control facilities, and industrial park land.⁴⁵ While the 1986 Act shortened the list of PAB-financed projects that qualified for tax exemption, it was clear that Congress was not willing to repeal the tax exemption for all PABs. For example, the exemption for solid waste disposal projects remained largely unchanged, and tax-exempt bond financing was even extended to qualified hazardous waste disposal facilities. Additionally, continued use of tax-exempt PABs for economic development generally was allowed through “qualified small issue bond” rules for issues of $10 million or less to finance manufacturing facilities.⁴⁶

The 1986 Act also placed restrictions on bonds issued for the benefit of non-profit organizations described in section 501(c)(3) (“501(c)(3)”) by creating a new category of bonds defined as “qualified 501(c)(3) bonds.”⁴⁷ Since the 1968 Act, which first subjected interest on bonds issued for private purposes to taxation, 501(c)(3) organizations had always been eligible for tax-exempt bond financing. Under the 1968 Act, 501(c)(3) projects were not treated as private so long as the bond proceeds were being used to finance a project related to the 501(c)(3)’s exempt purpose.⁴⁸ Thus, under the 1968 Act, bonds issued to benefit 501(c)(3) organizations were treated as bonds used to finance government projects. The 1986 Act restricted, but did not eliminate, the ability of 501(c)(3) organizations to fund projects with tax-exempt bonds. Under the 1986 Act, qualified 501(c)(3) bonds were classified as PABs, albeit tax-exempt PABs, and a 501(c)(3) entity, other than hospitals, could not benefit from more than $150 million of such bonds.⁴⁹ The 1986 Act also reduced the new ten percent private business use and private payment limits applicable to governmental use bonds down to five percent for qualified 501(c)(3) bonds.⁵⁰ In determining compliance with the private business use and private payment limits, however, activities in furtherance of the 501(c)(3)’s exempt purpose are not treated as private business use. The 1986 Act also exempted qualified 501(c)(3) bonds from the state tax-exempt bond volume cap (detailed in Section D below). Thus, qualified 501(c)(3) bonds, while technically classified as PABs, remained exempt from many of the rules applicable to other PABs because of the important and clear public purposes of 501(c)(3) organizations.

In summary, although Congress removed the ability to finance certain private facilities with PABs (e.g., convention and trade show facilities, industrial park land, automobile dealerships, restaurants, and liquor stores) in the 1986 Act, it also continued to allow tax-exempt financing for many types of private activities with a recognized public purpose or size-limited economic development purposes (e.g., financings that benefit 501(c)(3) organizations, including, among the large and diverse spectrum of nonprofit organizations, all nonprofit hospitals and nursing homes, private nonprofit colleges and universities, and cultural facilities such as nonprofit museums and performing arts facilities). Significantly, from 1913 forward, in addition to allowing tax-exempt financing for private parties deemed to provide a public benefit, subject to certain restrictions, where private parties are not involved, Congress has placed no restrictions on the types of projects and purposes that a state or local issuer can finance, instead leaving that determination to state law.⁵¹ These governmental financings include projects for highways, streets, sidewalks, bridges, water treatment and distribution, sewage collection and treatment, public secondary schools, public universities, courthouses, state and local adult and juvenile correctional facilities, storm drainage, public electric and gas utilities, mass transit, tunnels, public parks and recreation facilities, and cash flow borrowings, among many others.

Congress has also allowed tax-exempt PABs to finance the following purposes:

B. Arbitrage Bonds and Advance Refundings

Prior to 1969, state and local governments were not restricted from issuing tax-exempt bonds and earning an arbitrage profit by investing the bond proceeds at a yield that exceeded the yield on the bonds. To limit arbitrage motivated transactions, Congress ultimately developed two overlapping and somewhat redundant sets of rules — yield restriction and rebate — and Congress made these rules especially stringent as they applied to “advance refundings.”

The Tax Reform Act of 1969 (“1969 Act”)⁵⁸ added a provision that was codified as section 103(c) of the 1954 Code and treated “arbitrage bonds,” bonds issued where a “major portion” of the proceeds were expected to be used to acquire securities with a materially higher yield than the yield on the bonds, as taxable bonds. A “major portion” was defined as 15 percent. Thus, after the 1969 Act, 15 percent of the tax-exempt bond proceeds could be invested in higher yielding securities while the rest of the proceeds could not be invested in securities with materially higher yields except during a “temporary period” described below. “Materially higher yield” was originally considered one-half of a percentage point, but a 1972 Treasury Regulation reduced the definition of “materially higher yield” to mean one-eighth of a percentage point.⁵⁹ However, the 1969 Act had an exception that allowed for unrestricted investment of bond proceeds during a “temporary period” of up to three years if the issuer reasonably expected at the time of issuance that: (i) the project would be started within six months; (ii) work on the project would proceed with due diligence; and (iii) at least 85 percent of the net proceeds of the bonds would be spent on the project within three years.

Over the next several years Treasury Regulations tightened the arbitrage limits numerous times. Because tax and project revenues used to repay bonds were not subject to yield restrictions, these funds could potentially earn a yield materially higher than the bond yield. A Treasury Regulation was proposed in 1978 and finalized in 1979 that restricted the yield on the investment of any invested sinking fund not depleted annually.⁶⁰

The 1986 Act imposed further arbitrage limitations that required arbitrage profits, whether earned on governmental bonds or PABs, to be paid or “rebated,” so to speak, to the federal government.⁶¹ However, Congress provided for certain “spending exceptions” to the rebate rules, where the issuer owed no rebate if it spent the bond proceeds by certain specified deadlines.

Congress also limited the practice known as “advance refunding.” When prevailing interest rates fall sufficiently below the interest rate on an issuer’s bonds, if those bonds have call-protection features preventing their immediate redemption, an issuer could issue new tax-exempt bonds the proceeds of which are used to redeem the prior issue when it ultimately becomes callable. Until that later redemption of the prior issue, both issues would remain outstanding, each paying tax-exempt interest. Because Proposed Regulation section 1.103-7(e)⁶² had made it unclear whether an IDB could be advance refunded, the Revenue Act of 1978 (“1978 Act”)⁶³ allowed advance refundings of bonds issued to finance convention and trade show facilities, airports, docks, wharves, mass commuting facilities, and parking facilities while otherwise generally outlawing advance refundings of IDBs. The provision allowing advance refundings of those specific categories of IDBs was subsequently repealed by the 1984 Act.

With the 1986 Act, Congress prohibited advance refundings of all PABs (except for 501(c)(3) bonds) and generally limited 501(c)(3) and governmental bonds to just one advance refunding. Importantly, even where Congress acted to limit arbitrage and advance refunding bonds, it yet again only targeted those particular types of transactions, rather than completely eliminating tax-exempt bonds.

C. Volume Caps

Another major development in the history of tax-exempt bonds was the introduction of volume caps, first imposed by the Mortgage Subsidy Bond Act of 1980.⁶⁴ This volume cap limited the volume of qualified single-family mortgage revenue bonds issued in a given state based on prior mortgage originations but to an amount no less than $200 million. The 1984 Act maintained a separate volume cap for single family mortgage revenue bonds while establishing a new volume cap applicable to almost all other types of IDBs based on the greater of $150 per state resident or $200 million. However, even this new, general volume cap had exceptions. The volume cap did not apply to bonds for multi-family rental housing; convention or trade show facilities; or government-owned airports, docks, or mass commuting facilities.

The 1986 Act imposed a single, uniform volume cap across most categories of PABs, eliminating the separate volume cap for single family mortgage revenue bonds. The new volume cap was reduced to the greater of $50 per state resident or $150 million. Congress exempted qualified 501(c)(3) bonds; bonds issued to finance government-owned airports, docks, wharves and solid-waste disposal facilities; and qualified veterans’ mortgage bonds from the volume cap (although veterans’ mortgage bonds were subject to their own, separate volume cap). Thus, even as Congress limited the volume of tax-exempt PABs that could be issued, strong public policy considerations prompted Congress to allow certain PAB activities to be financed without volume caps.

To summarize: The history of tax-exempt bonds demonstrates that Congress gradually but continuously restricted the use of tax-exempt financing for private purposes, but it always made exceptions for certain types of private activities that it found to have an important public purpose. Congress restricted tax-exempt financing for certain activities by imposing (i) limits on the amount of private use; (ii) requirements that certain types of private activity bonds could only be issued for certain targeted activities; (iii) general limits on the amount of particular types of IDBs (and then PABs) that issuers could issue in a particular state; and (iv) limits on arbitrage bonds. When Congress enacted these restrictions, however, it was careful to focus these restrictions to only certain types of tax-exempt bonds rather than the tax-exempt bond system as a whole. Congress never restricted the issuance of governmental bonds for public purposes, including the financing of public facilities and public infrastructure. That is, to return to the old saying, Congress threw out some bathwater, but the importance of the “baby” was recognized so that it would remain safe and sound.

All of these restrictions were imposed through statutes, and the constitutional question — whether Congress had the power to tax interest on any particular type of state or local bond — receded into the background. But as Congress tightened the limitations on PABs and arbitrage techniques, participants in the state and local bond market began to consider using constitutional arguments to challenge the new restrictions.

D. Treating Certain Private Activity Bond Interest As An Item Of Tax Preference Under The Alternative Minimum Tax

In addition to the volume cap and other restrictions that Congress has imposed on tax-exempt PABs (other than qualified 501(c)(3) bonds), the 1986 Act also made interest on most tax-exempt PABs an item of tax preference for purposes of the alternative minimum tax (“AMT”).⁶⁵ Interest on qualified 501(c)(3) bonds and certain  PABs for housing purposes was exempted from AMT treatment. Some anecdotal evidence suggests that AMT treatment of most tax-exempt PABs has resulted in those bonds being purchased predominantly by taxpayers not subject to the AMT, creating a market for those bonds that is somewhat different from the market for non-AMT bonds. In any event, tax-exempt PABs subject to the AMT typically sell at a yield somewhat higher than the yield of a non-AMT public-purpose governmental bond with an equivalent credit rating.

IV. COURT CHALLENGES TO STATUTORY, REGULATORY AND INTERPRETIVE RESTRICTIONS

During the years since 1969, Treasury and the Service promulgated an ever-increasing number of regulations governing tax exemption. Many of these restrictions interpreted the statutory restrictions described above. Many others were developed directly in response to specific transaction types that had received scrutiny from the Service.

Despite the large number of states and local governments that regularly issue tax-exempt bonds, the overall volume of tax-exempt bond issues, and the complexity and subjectivity of some of the post-1968 statutory restrictions described above, there are relatively few federal court decisions dealing with the tax-exempt status of state and local government bonds and restrictions thereon. That can be explained, in part, by the pre-1968 simplicity of the statutory exemption. Almost all of the interpretive guidance interpreting post-1968 statutory restrictions has been, and continues to be, promulgated in the form of regulations, revenue rulings, revenue procedures, notices and private letter rulings. Precedents to be found in federal court decisions are few and far between.

Theoretically, the direct tax impact of a tax-exempt bond issue’s noncompliance with statutory and regulatory restrictions falls on the holders of the bonds (whose interest would be taxed in the event of the issuer’s noncompliance) rather than on the issuer of the bonds. As a practical matter, however, the effect of unfavorable interpretive guidance issued by the Service falls directly on the state and local government issuers by effectively precluding them from issuing tax-exempt bonds affected by that guidance due to the issuers’ inability to obtain the unqualified tax opinion typically demanded by prospective bondholders in the tax-exempt bond market.

In the 1978 Act, Congress recognized issuers’ procedural quandary by enacting section 7478 of the 1954 Code, allowing state and local government issuers to challenge, in Tax Court, unfavorable Service interpretations affecting a specific prospective bond issue. Under section 7478, an issuer would first request a private letter ruling approving a prospective issuance of bonds. If the Service denies the approval of the prospective bonds, the issuer may bring a declaratory judgement action in the Tax Court. Section 7478 is an exception to the general statutory rule prohibiting declaratory judgment-type relief in the federal tax area. Several of the court decisions mentioned in this Part IV are cases in which issuers utilized that section to gain standing to challenge a tax-exempt bond regulation or its interpretation.

In 1993, the Service announced that it was beginning an effort to audit tax-exempt bonds on a coordinated basis and invited public comment.⁶⁶ In 1995, the Service released guidelines for its agents to use in examining tax-exempt bonds⁶⁷ and began to develop and staff a systematic program to audit state and local government issuers’ compliance with the many statutory and regulatory restrictions on tax-exempt bonds enacted and promulgated over the previous three decades. That audit effort has grown steadily over the years, both in number of audits and scope of issues raised by the Service’s enforcement personnel. However, the audit program has engendered few, if any, federal court decisions. Despite the fact that these compliance audits take place at the level of the state or local government issuer, the federal tax rules are such that collection of tax on bond interest, if issuer noncompliance is alleged, can occur only at the bondholder level. A state and local government issuer’s legal liability for noncompliance would not be for tax owed to the federal government, but rather to the taxed bondholders who could bring a claim against the issuer alleging breaches of contractual covenants relating to the tax-exempt status of the bonds.

The Service’s desire to avoid the administrative and logistical challenges it would face in an attempt to collect tax from hundreds or thousands of holders of any given bond issue, and issuers’ desire to avoid the threat of protracted litigation with bondholders were the Service to make such an attempt, have combined to result in negotiated settlements between the Service and issuers in almost all cases in which noncompliance issues are raised in tax-exempt-bond audits. These settlements generally take the form of a “closing agreement” under which the issuer agrees to pay the Service a negotiated amount of money, and at times agrees to redeem some or all of the bonds, in exchange for the Service’s agreement not to attempt to collect tax from bondholders. The prevalence of closing agreements to resolve state and local governments’ disputes with the Service involving compliance with tax-exempt bond restrictions is the principal reason there is a scarcity of judicial precedents in the tax-exempt bond area.

Notwithstanding the procedural and practical difficulties of bringing disputes over the tax-exempt status of bonds into a federal courtroom, state and local governments have managed to challenge some statutory, regulatory and interpretive restrictions over the years. Among the most important challenges have been:

Treasury accepted the result in Fairfax County (at least with respect to private conduit borrowers) but its U.S. obligation argument was later codified in section 103(h) of the 1954 Code (which later became section 149(b)). Both Washington and Tucson were effectively reversed by Congress in legislation.

South Carolina directly challenged the constitutionality of a restriction that required tax-exempt obligations to be issued in registered form.⁷² However, by all accounts, the registration requirement in Section 310 of TEFRA did very little to hamper states’ ability to raise capital through the issuance of bonds. According to the South Carolina Special Master’s Report, “[t]he state and local officials that the plaintiffs called as witnesses acknowledged that they had neither reduced borrowings nor experienced any difficulties in raising funds subsequent to the passage of the registration requirement.”⁷³ The Report also states that “[t]he burdens of establishing and maintaining a system of registered municipal bonds do not weigh heavily upon the States.”⁷⁴

The Court in South Carolina held that Section 310(b)(1) of TEFRA, which added section 103(j) of the 1954 Code (which became section 149(a)(2) of the Code), did not violate the principle of intergovernmental tax immunity nor implicate the Tenth Amendment. The Court then undertook, in dicta, a broad discussion, well beyond the narrow application of Section 310 of TEFRA, as to the reach of the Tenth Amendment generally and whether tax-exempt bonds were constitutionally protected under Pollock or were subject to Congressional discretion. As a result of South Carolina, some commentators believe that there are no limits to what Congress could do to limit the tax-exempt status of municipal bonds.⁷⁵ However, as discussed below, others believe, even post-South Carolina, that certain limits continue to exist.⁷⁶

Because the Court only ruled on Section 310 of TEFRA and not on the question of the direct taxation of interest on all municipal bonds, which might be found to weigh heavily on states’ ability to raise capital, the Court’s ruling should be viewed as inapplicable to, and therefore not dispositive of, whether a tax on the interest on all municipal bonds would be constitutional.⁷⁷

Additionally, since South Carolina, the Court has addressed Tenth Amendment and state sovereignty issues on a number of occasions in cases that do not involve tax law.⁷⁸ The implications of those Tenth Amendment/state sovereignty cases in the context of tax law generally and intergovernmental tax immunity specifically, are beyond the scope of this paper.

V. RECENT LEGISLATION AND LEGISLATIVE PROPOSALS

A. Congress Solves Specific Economic and Natural Disaster Problems with Tax-Exempt Bonds

On numerous occasions, Congress has turned to tax-exempt bonds as a well-established, quick, effective, and proven tool to alleviate specific hardships caused by economic circumstances or natural or man-made disasters.

Recent examples include:

B. Tax Credit Bond Alternatives to Tax-Exemption

Congress also has revised the Code on a number of occasions to allow for the issuance of tax credit bonds that either pay a direct subsidy to the borrower to reduce the interest cost or allow a tax credit to the bond holder. These bonds are designed to spur particular types of projects or to promote economic activity more generally.

Recent examples include the following categories of qualified tax credit bonds⁸⁶ added to the Code in 2005, 2008 and 2009:

In addition, in 2009 Congress authorized two other categories of tax credit bonds in other sections of the Code that were not on the list of qualified tax credit bonds:

C. Limitations on Benefit of Tax Exemption — Taxing Tax-Exempt Bonds

Historically, any attack on tax-exempt bonds has taken the form of (i) restricting the purposes for which bonds may be issued; (ii) imposing volume caps limiting the amount of certain types of private activity bonds and tax credit bonds that may be issued; (iii) imposing arbitrage restrictions on tax-exempt bonds; or (iv) limiting the permitted number of advance refundings.

Recent budget proposals have attempted to take a different path with regard to tax-exempt bonds by generally retaining the exemption of interest on tax-exempt bonds but taxing a portion of the interest on those bonds for investors in higher tax brackets. None of those proposals were enacted. It remains to be seen whether these proposals failed due to a concern about the Tenth Amendment, continued recognition of the policy importance of retaining the tax exemption of interest on state and local bonds, specific political concerns, general political gridlock, or a combination of all of these factors.

CONCLUSION

This paper has focused on the legal — i.e., constitutional, statutory, regulatory and judicial — history of the federal tax exemption of state and local bonds. An in-depth discussion of the policy and political debates underlying the development of that history is beyond the scope of this paper. However, those discussions almost always involve debates about (i) whether the federal government’s need for additional tax revenues outweighs state and local governments’ need for lower-cost capital for public facilities and public infrastructure projects; (ii) whether, when there is consensus that state and local governments’ public facility and infrastructure financing costs should be federally subsidized, the interest exemption is the most efficient means of doing so; and (iii) whether it is “fair” for tax-exempt bonds to provide a means by which higher-income taxpayers limit their income subject to federal income taxation.

Over many decades, reasonable people have made rational arguments on both sides about the “right” answers to these questions. But the historical fact remains that, notwithstanding the many attempts to eliminate tax-exempt bonds from the early years through 1951, Congress repeatedly chose not to do so. After 1951 Congress has chosen to manage the appropriate use of tax-exempt bonds. Throughout the more than 100 year history of tax-exempt bonds, Congress has never significantly restricted the use of tax-exempt bonds for purely governmental purposes such as public facilities and public infrastructure. During that same 100-year period, state and local governments have regularly used tax-exempt bonds to improve and expand public facilities and public infrastructure in order to realize the attendant benefits that those facilities and infrastructure yield in terms of economic activity, education, healthcare, public safety, and justice.