Re: REG - 165706-01 - Proposed regulations on the definition of refunding issue applicable to tax-exempt bonds issued by states and local governments.
Liberty Place, Suite 700
325 Seventh Street, NW
Washington, DC 20004-2802
(202) 638-1100 Phone
Tuesday, July 9th 2002
The Honorable Charles O. Rossotti
Internal Revenue Service
Post Office Box 7604
Ben Franklin Station
Washington, DC 20044
Dear Commissioner Rossotti:
On behalf of the American Hospital Association's (AHA) nearly 5,000 hospital, health system and other health care provider members, we welcome the opportunity to provide these comments on the proposed regulations regarding the definition of refunding issue applicable to tax-exempt bonds issued by states and local governments (REG-165706-01), published in the Federal Register on April 10, 2002.
The proposed regulations would modify the definition of "refunding issue" in regulations under section 150 of the Internal Revenue Code of 1986, as amended. While important to all issuers and beneficiaries of tax-exempt bonds, the proposed regulations are specifically directed at a particular type of tax-exempt bond issue that principally benefits nonprofit hospitals and health care systems. The proposed regulations principally concern so-called "acquisition financing" tax-exempt bonds that are issued in connection with affiliations of hospitals and health care systems. The preamble to the proposed regulations states that "in question generally is whether bonds issued in connection with a combination of two or more 501(c)(3) organizations to refinance outstanding bonds should be characterized as refunding bonds."
Announcement 2002-43, released at the same time as the proposed regulations, sets forth a closing agreement program that states that it "applies to issues of state or local bonds issued in connection with hospital affiliation transactions where two or more existing 501(c)(3) organizations ... agreed to merge their operations by selling either the assets of the Sellers or control of the Sellers to a new or pre-existing 501(c)(3) organization that the Sellers jointly control." The AHA welcomes the statement in the Announcement that the Internal Revenue Service (IRS) "recognizes the policy reasons for the hospital affiliation transactions."
Acquisition financing can play a critically beneficial role for America's nonprofit health care organizations and the communities they serve. At a time when these tax-exempt, nonprofit hospitals are burdened by rising labor costs, increased levels of uncompensated care, and the need to meet the demands of disaster readiness, including the threat of bioterrorism, their limited resources should be used primarily to care for patients in their communities. Hospitals need to invest continuously in technology and facilities, and existing facilities must be converted to new uses or replaced. Restructuring by acquisition is one way nonprofit health care organizations are successfully meeting these challenges.
Although the U.S. Department of Treasury and the Internal Revenue Service (IRS) have recognized the "policy reasons" for issuing tax-exempt bonds in connection with hospital affiliations, the proposed regulations would implement complex and burdensome new restrictions, repealing many of the benefits of these transactions. We feel such new restrictions are unnecessary and inappropriate.
The AHA supports affirmation of the "change of obligor" refunding rule.
In defining "refunding issue," the current regulations, which were published in 1993, state the framework rule that an "issue is not a refunding issue to the extent that the obligor of one issue is neither the obligor of the other issuer nor a related party with respect to the obligor of the other issue." The regulations also clarify that, for conduit bond issues, the conduit borrower, such as a section 501(c)(3) hospital, is the "obligor." The proposed regulations generally affirm this framework rule and "clarify that the determination of whether persons are related for purposes of the change of obligor exception is generally made immediately before the transaction." We agree that the "change of obligor" refunding rule is appropriate and workable, and support the general affirmation of the "change of obligor" rule in the proposed regulations. In addition, we also agree that the determination of whether persons are related for purposes of this rule is generally made before the transaction.
AHA supports a rule permitting transfers of membership interests to be treated as asset acquisitions.
Many hospital affiliations are accomplished by transfers of membership interests, or other transfers of control, rather than through transfers of underlying hospital assets. For a variety of bona fide reasons, this approach is often far less burdensome and less costly for hospitals seeking to affiliate. The proposed regulations appear to acknowledge the policy reasons for treating such transfers of control as asset acquisitions. In particular, the proposed regulations would provide that acquisition of control of a 501(c)(3) organization through the acquisition of stock, membership interests or other means be treated as an "acquisition transaction." We agree that transfers of membership interests that transfer control of an organization should generally be afforded the same treatment as transfers of assets of the organization under the tax-exempt bond regulations.
One problem with the proposed regulations, however, is that they do not expressly state that a transfer of control through membership interests of an organization may be treated as the acquisition of assets of that organization. Rather, the proposed regulations literally appear to provide only that a tax-exempt bond financing issued in connection with such a transfer may not be a refunding issue; the proposed regulations do not expressly state what assets are acquired with proceeds of the bonds. We feel that the regulations should expressly provide that a transfer of control of an organization through transfer of membership interests can be treated as a transfer of all (or certain) assets of that organization.
The special restrictions in the proposed regulations are inappropriate and unnecessary.
Although the proposed regulations appear to generally acknowledge the policy reasons supporting tax-exempt acquisition financing, they also would place special restrictions on a particular type of financing that would remove many of the benefits of acquisition financing. These new special restrictions would apply to bonds "issued in connection with a transaction between affiliated persons." This new category of bonds, subject to special restrictions, is defined very broadly because, for this purpose, persons are "affiliated" for one of two reasons: (1) if, at any time during the six months prior to the transaction, more than 5 percent of the voting power of the governing body of either person is in the aggregate vested in the other person and its directors, officers, owners or employees; or (2) if, during the one-year period beginning six months prior to the transaction, the composition of the governing body of the acquiring person (or any person that controls the acquiring person) is modified or established to reflect (directly or indirectly) representation of the interests of the acquired person or the person from whom assets are acquired (or if there is an agreement, understanding, or arrangement relating to such a modification or establishment during that one-year period).
The proposed special restrictions that would apply to bonds "issued in connection with a transaction between affiliated persons" are that (1) the refinanced issue must be redeemed on the earliest date on which it may be redeemed; and (2) the refinancing issue must be treated for all purposes of sections 141 through 150 as financing the assets that were financed with the refinanced issue (the "step in the shoes" restriction).
The proposed regulations' preamble states that these new restrictions "are intended to prevent overburdening in the case of transactions between affiliated persons that contain certain economic characteristics of a refunding." Neither the Treasury nor the IRS has explained - in the preamble or anywhere else - why the transactions subjected to these new special restrictions are properly viewed as an "overburdening" of the tax-exempt bond markets - or why such transactions fail to qualify as tax-exempt bonds without the new special restrictions. The AHA in particular notes that the Treasury and the IRS have acknowledged: (1) that there are bona fide policy reasons for these transactions; (2) that the determination of whether persons are related for purposes of the "change of obligor" rule is generally made immediately before the transaction; and (3) that a transfer of control of membership interest can appropriately be treated as an acquisition. In addition, the proposed regulations provide that the transactions subjected to these new special restrictions are appropriately treated as new money acquisition bond issues, rather than as refunding bond issues.
We feel that these transactions do not involve an "overburdening." In fact, Congress has expressly authorized the use of qualified 501(c)(3) bonds to acquire existing property because the restriction on use of proceeds of qualified 501(c)(3) bonds to acquire existing property contained in section 147(d) of the Code expressly does not apply to qualified 501(c)(3) bonds. This rule, coupled with the "change of obligor" refunding rule, plainly implies that two or more new money bond issues may appropriately finance the same assets, provided that the obligors of those bond issues are not the same (or related parties). Therefore, we feel that these new restrictions are inappropriate.
Moreover, the very broad scope of the "affiliated persons" rule appears to bear no relationship to the concern expressed in the proposed regulations' preamble that some transactions "contain certain economic characteristics of a refunding." For example, consider the following transaction: Suppose that hospital system D seeks to acquire the assets of hospital A. Hospital system C holds the sole membership interest of A. Hospital system D issues tax-exempt bonds in an amount equal to the fair market value of A's assets. At the same time, C transfers the membership interest in A to D. As a part of this transaction, D agrees that one of the 24 members of its governing board may be appointed by C. Under the proposed regulations, this transaction will be treated as a new money acquisition financing only if (1) any outstanding bonds of A are redeemed on their first call date; and (2) D's bonds are treated as financing the same assets as A's outstanding bonds. There is no basis for concluding that an agreement to permit the seller to appoint governing board members of the buyer causes a transaction to have "economic characteristics of a refunding."
Indeed, such a transaction would only have the economic characteristics of a refunding if the seller (C) were given rights to control the governing board of the buyer (D). In such a case, however, the transaction would appropriately be viewed as a refunding, and there would be no need for the new special restrictions.
The "step in the shoes" restriction inappropriately limits how borrowers can allocate tax-exempt bond proceeds.
Treasury regulations finalized in 1993 and 1997 generally establish the principle that issuers and 501(c)(3) organization borrowers of tax-exempt bonds may use any reasonable, consistently applied accounting method to account for expenditures of a bond issue. These regulations expressly state that a specific tracing method is reasonable. Thus, the general rule is that a 501(c)(3) borrower has the authority to "target" how tax-exempt bond proceeds are spent on specific assets. This "step in the shoes" restriction in the proposed regulations is plainly inconsistent with this general allocation rule. Indeed, in many cases this new special restriction leads to results that would appear to be plainly unreasonable, such as when it would require proceeds of new money bonds to be allocated to assets in cases where the fair market value of those assets is far less than the bond proceeds that are treated as "spent" on them.
The proposed regulations also provide no indication of how the "step in the shoes" restriction furthers a policy of preventing "overburdening." We feel that the new "step in the shoes" restriction should not be adopted in final regulations.
The IRS tax-exempt bond enforcement program should be reformed.
Publication of these proposed regulations responds to IRS examinations of acquisition financing bond issues that benefited seven hospital systems, because announcement was released at the same time as the proposed regulations and expressly makes reference to the proposed regulations.
The AHA applauds the resolution of disputes between the IRS and nonprofit hospitals through publication of prospective published guidance. We feel, however, that IRS examinations of acquisition financing bonds have been unnecessarily and inappropriately disruptive of the tax-exempt bond markets and tax-exempt financing for nonprofit hospitals. These examinations were initiated in an apparently coordinated manner within a short time and conveyed to the investing public that the IRS was implementing a targeted program to challenge these transactions.
We understand that the IRS tax-exempt compliance program has a legitimate function to monitor compliance with the rules set forth in section 103 and 141 through 150 of the Code; however, the tax-exempt bond compliance program has not been administered in a manner that adequately takes into account the particular sensitivities of the tax-exempt bond markets or the special status of state and local government bonds. The AHA recommends that the IRS Guidelines for Municipal Financing Arrangements (contained in IRM 7.6.2, Chapter 5) be specifically amended so that the Tax-Exempt Bond Program, effectively implemented by the IRS, would monitor tax compliance with the minimum possible disruption to the tax-exempt bond markets.
According to the IRS, multiple examinations of similar bond issues are necessary to enable the IRS to gather information and appropriately respond to new developments. In the case of acquisition financing bonds, however, many of the important legal issues should have been evident to the IRS in the course of the first examination. In effect, the IRS enforcement program has caused unnecessary disruption of the tax-exempt bond markets because of implementation of an incautious enforcement initiative and an undue delay in stating a legal analysis of acquisition financing transactions.
We urge the IRS to be much more deliberative in the future in administering the tax-exempt bond enforcement program. In particular, where possible, we suggest that the IRS should attempt to carefully consider and develop a preliminary legal analysis before undertaking any further targeted enforcement initiatives directed at a particular type of financing. Such legal analysis should involve coordination between the Tax-Exempt Bond Program and the Office of Chief Counsel, and, when appropriate, the Office of Tax Legislative Counsel of the Treasury.
Thank you for the opportunity to provide these comments. If you have any questions, or would like to discuss these issues further, please contact the AHA's Mike Rock at (202) 626-2325, or email@example.com.
Executive Vice President