Santa Rosa Seeks Declaratory Judgment Finding Bonds Exempt

Santa Rosa states that the proposed bonds will finance "the project," consisting of a pipeline, four pumping stations, tanks, connection equipment, control systems, power systems, and a storage tank located at a geyser field. The principal component of the project is the pipeline running from the city's existing sewage system to the thermally active geyser field.

The city contends that the project will serve several public purposes, such as the disposal of the city's wastewater, and allow the city to release the treated water into the Russian River at an alternative location that will not degrade the quality of the river relative to the current wastewater release location. The city also asserts that the treated wastewater will be delivered to areas that have chronic shortages of irrigation water. Santa Rosa, therefore, argues that the project qualifies as an output facility under reg. section 1.141-7T and does not meet the Private Business Tests of section 141(b).

PETITION FOR DECLARATORY JUDGMENT (Governmental Obligations)

Pursuant to Section 7478 of the Internal Revenue Code of 1986, as amended (the "Code"), the Petitioner hereby petitions for a declaratory judgment that approximately $130,000,000 principal amount of City of Santa Rosa, California, Wastewater Revenue Bonds (the "Proposed Bonds") representing a prospective issue of bonds to be issued by the City of Santa Rosa, California (the "Petitioner" or the "City") are obligations the interest on which will be excludable from gross income of the holders thereof pursuant to Code Section 103(a).

PROCEDURAL MATTERS

(1) The Petitioner is the City of Santa Rosa, California. The City's address is * * * Santa Rosa, California 95402-1678, Attention: Rene Chouteau, Esq., City Attorney.

(2) The Petitioner is a prospective issuer of governmental obligations described in Code Section 103(a) and on June 2, 1998, the City Council of the City adopted a resolution authorizing the issuance of the Proposed Bonds in a principal amount not to exceed $130,000,000.

(3) On September 17, 1998, the City issued its taxable $31,000,000 principal amount of Variable Rate Demand Wastewater Revenue Bonds, Series 1998A (Taxable), dated September 17, 1998 (the "Series 1998A Bonds") the proceeds of which were and will be used to pay costs of the first phase of construction and acquisition of the Project (described in the Statement of Facts, paragraph (8) herein). A portion of the Proposed Bonds in the amount of approximately $31,000,000 would be used to refund, on a tax-exempt basis within 90 days of the date of issuance thereof, the Series 1998A Bonds, and the remaining portion of the Proposed Bonds would be used to finance the remaining costs of the Project.

(4) On September 28, 1999, the City submitted a Request for Ruling Under I.R.C. Section 141 to the Commissioner of Internal Revenue CC:DOM:CORP:TSS in Washington, D.C., requesting a determination that the Proposed Bonds would not meet the "private business tests" under Code Section 141 and therefore interest on the Proposed Bonds would be excludable from gross income under Code Section 103(a).

(5) On April 3, 2000, the Internal Revenue Service responded to the City's Request for Ruling and ruled that the Proposed Bonds will meet the "private business tests" under Code Section 141 and therefore interest on the Proposed Bonds will be includable in gross income under Code Section 103(a). A copy of the Internal Revenue Service's ruling is attached hereto as Exhibit "A".

(6) The City has exhausted its administrative remedies with the Internal Revenue Service.

ALLEGATIONS OF ERROR

(7) The following errors were committed by the Respondent, Commissioner of Internal Revenue, in determining that the interest on the Proposed Bonds will be includable in gross income under Code Section 103(a):

PRIVATE SECURITY OR PAYMENT TEST -- CODE SECTION 141(b)(2)

(a) The Commissioner erred in determining that the Project was used for a private business use within the meaning of Code Section 141(b)(1) rather than for a governmental use.

(b) The Commissioner erred in determining that payment of the Proposed Bonds is secured by payments in respect of property to be financed with proceeds of the Proposed Bonds (i.e., the Project) within the meaning of Code section 141(b)(2).

(c) The Commissioner erred in concluding that the Sewer Fees (defined in the Statement of Facts, paragraph (8) herein) are payments in respect of property used for a private business use (i.e., the Project). The Sewer Fees are paid with respect to the governmental function of the Project being safe, sanitary and environmentally sound disposal of sewage.

(d) The Commissioner erred in failing to treat the facts related to the Proposed Bonds as being analogous to the facts in Treas. Reg. sections 1.141-4(g), Example 4.

(e) The Commissioner erred in treating the facts related to the Proposed Bonds as analogous to the facts in Treas. Reg. section 1.141-4(g), Example 5.

PRIVATE BUSINESS USE TEST -- CODE SECTION 141(b)(1)

(f) The Commissioner erred in concluding under Treas. Reg. section 1.141-3(b)(1) that the Treated Water to be delivered by the City to the Company under the Construction Contract (defined in the Statement of Facts, paragraph (8) herein) resulted in a "special legal entitlement" to the Company causing a nongovernmental use of the proceeds of the Proposed Bonds. The provision of Treated Water to the Company and other Treated Water Users (defined in the Statement of Facts, paragraph (8) herein) is not the governmental purpose of the Project and is an incidental use of the Project.

(g) The Commissioner erred in concluding under Treas. Reg. section 1.141-3(c)(1) that the Company and the Treated Water Users are not using the Project as members of the general public.

PRIVATE BUSINESS TESTS APPLIED TO OUTPUT FACILITIES -- CODE SECTION 141(b) AND TREAS. REG. SECT. 1.141-7T

(h) The Commissioner erred in concluding that the Project is not an output facility within the meaning of Treas. Reg. section 1.141- 7T(a).

(i) The Commissioner erred in concluding that the Specific Performance Provisions of the Construction Contract (defined in the Statement of Facts, paragraph (8) herein) are "specific performance rights" within the meaning of Treas. Reg. section 1.141-7T(c)(5).

STATEMENTS OF FACTS

(8) In support of the above allegations of error the Petitioner relies upon the following facts:

(a) The City is organized under the Constitution and laws of the State of California and, under those laws, has taxing powers, police powers, and powers of eminent domain and as such is a political subdivision of the State of California under Code Section 103.

(b) The City owns and operates a subregional sewage and treated water enterprise system (the "Sewage and Treated Water Enterprise"), which includes facilities for collection of sewage and other effluent, treatment of the sewage and other effluent, tertiary treatment of the wastewater produced from this treatment process ("Treated Water"), a reservoir for storing the Treated Water and pipelines and other facilities for the transportation of the Treated Water to users and to disposal points.

(c) The Sewage and Treated Water Enterprise serves approximately 250,000 people in central Sonoma County, California, including the City and the cities of Rohnert Park, Cotati, and Sebastopol, as well as a portion of the unincorporated area of Sonoma County. Because of significant population growth, finding an acceptable method to dispose of increased quantities of the Treated Water has become a serious problem for City. Different disposal alternatives were explored and the City selected the "Geysers Alternative", an alternative under which the Treated Water will be transported via a pipeline to electric utility, industrial, agricultural, commercial, residential, and other appropriate users of the Treated Water (the "Treated Water Users").

(d) Under the Geysers Alternative, a pipeline (the "Pipeline"), four pumping stations, tanks, connection equipment, control systems, power systems, and a storage tank (collectively the "Project") will be constructed at an anticipated cost of $128,425,749.00. The Pipeline will transport the Treated Water to Treated Water Users and will terminate at a thermally active geyser field (the "Geyser Field") where a portion of the Treated Water will be piped into a storage tank (the "Storage Tank") located at the Geyser Field.

(e) The City has entered into a construction agreement (the "Construction Agreement") among the City and Union Oil Company of California, NEC Acquisition Company and Thermal Power Company (collectively the "Company") under which the City agrees to deliver approximately 11 million gallons of Treated Water per day to the Storage Tank located at the Geyser Field. The Company will not pay for the Treated Water it receives. The Company will provide electricity necessary to operate three of the pumping stations.

(f) The Treated Water will be taken from the Storage Tank by the Company and injected into the ground, become heated, and produce steam which will be used to generate electricity. Pursuant to the Construction Agreement, the Company will, at its own cost, construct (or provide for the construction of) the injection facilities that will inject the Treated Water into the ground (the "Geyser Injection Facilities"). The City has no interest in the Geyser Injection Facilities or the electric generating facilities of the Company, and the City will not receive any revenues from the generation of electricity by the Company or payment for Treated Water received by the Company.

(g) The Pipeline portion of the Project consists of two sections. The first section is a 29 mile long pipeline (the "Multi- Use Pipeline") from the City's existing treatment plant and reservoir to the base of a mountain (the "Mountain"). The second section is a 12 mile long pipeline (the "Geysers Pipeline") beginning at the base of the Mountain and running to the top of the Mountain where the Storage Tank and the Geyser Injection Facilities are located. The Multi-Use Pipeline has an actual capacity of 40 million gallons of Treated Water per day. The Geysers Pipeline has an actual capacity of 12.1 million gallons of Treated Water per day.

(h) It is expected that, on average, the Multi-Use Pipeline and the Geysers Pipeline will carry 11 million gallons of Treated Water per day to the Storage Tank located at the Geyser Injection Facilities. Of the 40 million gallon-per-day capacity of the Multi- Use Pipeline, 29 million gallons per day will be available for delivery of Treated Water to the general public located along the route of the Multi-Use Pipeline. The remaining 11 million gallon-per- day capacity of the Multi-Use Pipeline will be used to deliver Treated Water to the Storage Tank located at the Geyser Field. The Multi-Use Pipeline cannot carry more than 12.1 million gallons of water per day to the Storage Tank because of the maximum 12.1 million gallons per day capacity of the Geysers Pipeline. Most of the delivery of Treated Water to the general public by the Multi-Use Pipeline will occur during the winter months when more Treated Water is available.

(i) The Project serves several public purposes. The most important purpose is the disposal of City's wastewater. In addition, the Project allows the City to release the Treated Water into the Russian River at an alternative location that will not degrade the quality of the River to the same extent as the present release location. Finally, the Project allows the Treated Wastewater to be delivered to areas that have chronic shortages of irrigation water.

(j) Treated Water Users include growers (there are a number of vineyards in the area), ranchers, homeowners in large rural settings, parks, and similar uses. Growers in these areas consist of individuals, partnerships and corporations and vary in size from small to very large. Because of the design of the Project and traditional irrigation methods, water will not be drawn from the Pipeline and used directly for irrigation. Instead, Treated Water Users will take water from the Pipeline during the winter and spring and use it to fill irrigation reservoirs and ponds located on their property. It is unlikely that these new Treated Water Users will have ponds or reservoirs currently in place and; therefore, each user will most likely have to incur significant capital expenditures for construction of ponds and reservoirs and related pumping and connection equipment. Because of the cost of these capital improvements, Treated Water Users will want to ensure that Treated Water will be available to them before they incur these costs and; therefore, the Treated Water Users will enter into contracts (the "Treated Water Contracts") with the City, similar to the Construction Contract, which will guarantee a certain amount of Treated Water to that user at a negotiated cost. Aggregate amounts received from the Treated Water Contracts will not exceed 5 percent of debt service on the Proposed Bonds. The Treated Water Contracts will be for periods of ten to twenty years, depending on the individual circumstances of each Irrigation User. In addition, in order to encourage irrigation use of the Treated Water, the City may use general wastewater enterprise funds to make grants or low-interest rate loans to prospective Treated Water Users to help finance the cost of the irrigation improvements and equipment.

(k) Debt service on the Proposed Bonds is secured and paid by general rates and charges ("Sewer Fees") imposed on members of the general public receiving sewer service from the Sewage and Treated Water Enterprise (the "Ratepayers"). The City anticipates that Sewer Fees will have to be increased to pay for the Project. The Sewer Fees are set by City ordinance which provides a generally applicable published rate schedule. There are no specially negotiated rate arrangements for the disposal of sewage. The Sewage and Treated Water Enterprise is available to and used by the general public and Sewer Fees charged are generally applicable and uniformly applied within the meaning of Treas. Reg. section 1.141-3(c)(2).

(l) If Treated Water is not delivered or taken in accordance with the Construction Contract, the parties are required to mediate any differences. If mediation fails, the non-defaulting party can either declare the defaulting party in breach of the Construction Contract or seek specific performance of the Construction Contract. If the Construction Contract is breached by the Company during the first two-thirds of its term, the City can terminate the Construction Contract and collect a predetermined amount of damages (the "Liquidated Damages"). Specific performance rights are described in section 21 of the Contact (the "Specific Performance Provisions"). Under that section, a non-defaulting party can request a temporary restraining order and a preliminary injunction to prevent a default under the Construction Contract or to compel performance by the defaulting party. The City does not expect that the Construction Contract will be breached by either party or that the Company will pay the City any liquidated damages.

(m) The Proposed Bonds will have a maximum maturity of 30 years and an expected weighted average maturity of 22 years. The expected economic life of the Project is at least 50 years. The expected yield of the Proposed Bonds is 5.5% per annum. It is expected that a portion of the proceeds of the Proposed Bonds will be invested at an unrestricted yield for a temporary period not to exceed three years as permitted in Treas. Reg. section 1.148-2(e)(2).

WHEREFORE, Petitioner prays for a judgment declaring that:

(1) interest on the Proposed Bonds will be excludable from gross income for federal income tax purposes under Code Section 103(a),

(2) the Proposed Bonds will not meet the Private Security or Payment Test under Code Section 141(b)(2),

(3) the Proposed Bonds will not meet the Private Business Use Test under Code Section 141(b)(1),

(4) the Sewer Fees will not be treated as payments within the meaning of Code Section 141(b)(2) and Treas. Reg. section 1.141-2 and section 1.141-4,

(5) the Project will not be deemed to be used for a private business use within the meaning of Code Section 141(b)(1) and Treas. Reg. section 1.141-2 and section 1.141-3,

(6) the Project will be considered an output facility under Treas. Reg. section 1.141-7T and will not be treated as meeting the Private Business Tests of Code Section 141(b) by reason of the application of Treas. Reg. section 1.141-7T, and

(7) for such other and further relief as the Court may order.

Dated: June 30, 2000

[Editor's Note: The attachment has been omitted. However, this document in its entirety can be obtained through our Tax Analysts' Access Service as Doc 2000-19234 (18 pages).]