A water agency's bonds financing lead pipe replacements do not flunk the private security or payment test, so they stay tax-exempt

Plain-English summary

A public water agency issued tax-exempt bonds partly to replace privately owned lead service lines, the pipes running from the agency's main to each customer's building, to reduce lead in the drinking water. Because some of those replaced pipes serve customers who run a business, the agency expected the bonds to meet the "private business use" test under section 141. Interest on a state or local bond stops being tax-exempt only if the bond is a private activity bond, which requires meeting both the private business use test and the private security or payment test. The agency asked the IRS to rule that its bonds do not meet the second test. The IRS agreed: only the portion of customer rate payments attributable to replacing lead lines for business-user customers counts as a private payment, and the agency represented that share is under 10 percent of the bonds' debt service. Because the private payments do not exceed 10 percent, the bonds do not meet the private security or payment test, so they are not private activity bonds on that ground and the interest remains tax-exempt.

Ruling snapshot

• Question: Do the agency's bonds meet the private security or payment test of § 141(b)(2)?
• Outcome: Approved (IRS ruled the bonds do not meet the private security or payment test)
• Key authorities: IRC § 103, § 141(a), (b); Treas. Reg. § 1.141-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202144007 Third Party Communication: None
Release Date: 11/5/2021 Date of Communication: Not Applicable
Index Number: 141.00-00, 141.01-02
Person To Contact:
-------------------------------------------------- ----------------------, ID No. -------------
------------------------------------------------------------ Telephone Number:
--------------------- -------------------
------------------------------------------------ Refer Reply To:
---------------------------- CC:FIP:5
---------------------------- PLR-103012-21
Date:
August 10, 2021

LEGEND

Agency = ---------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
-----------------------

Bonds = ------------------------------------------------------------
------------------------------------

State = -----------------------

City = ---------------------------------

Year 1 = -------

State’s Department = ---------------------------------------------------------------------------------

Date 1 = ---------------------

Year 2 = -------

Date 2 = --------------------------

x = --

y = ----

Date 3 = ----------------

z = -----------
PLR-103012-21 2

Dear --------------:

This is in response to the request on behalf of the Agency for a ruling that the Bonds will
not meet the private security or payment test under § 141(b)(2) of the Internal Revenue
Code.

Facts and Representations

You make the following factual representations. The Agency is a supplier of water in
the State and provides water in an area covering the boundaries of the City and many of
its suburbs.

Under the State’s drinking water regulations, the Agency must sample the water in its
system to determine whether the concentrations of lead exceed certain levels (the “lead
action level”), which would trigger actions including corrosion control treatment and
public education. The water delivered by the Agency does not contain lead, nor do any
facilities or distribution lines owned by the Agency. However, the corrosive quality of
water can cause lead from service lines, that is, the pipes from the Agency’s distribution
line in the street to the residence or other building being served, to leach into the water
supply, causing a health risk. The service lines are owned by the owner of the property
being served. The only way to eliminate this health risk completely is to remove the
lead service line (“LSL”) and replace it with a copper service line.

In Year 1, the Agency’s water sampling results showed an exceedance of the lead
action level. The Agency conducted tests and recommended a treatment method,
which was rejected by the State’s Department, which ordered the Agency to implement
a different treatment method on or before Date 1. The Agency applied to the United
States Environmental Protection Agency (“EPA”) for a variance to implement a lead
reduction program plan (“LRPP”) in lieu of the treatment method ordered by the State’s
Department. On Date 2, the EPA authorized the Agency to implement the LRPP. This
would require replacement of x percent of the LSLs within the Agency’s service area
each year so that all LSLs are replaced within y years. The replacement of LSLs will
achieve additional lead removal benefits that could not otherwise be achieved under the
treatment ordered by the State’s Department.

The Agency will replace LSLs for both residential and commercial customers. The
customers own the existing LSLs and will own the pipes replacing the LSL (“LSL
Replacements”). A portion of the LSL Replacements could be for residential customers
who treat their home as a rental property or for residential customers that are running a
business out of their home.

Either the Agency will directly pay the costs of replacing the LSL or the Agency’s
customer receiving an LSL Replacement will pay those costs and the Agency will
reimburse the customer for a portion of the costs. The Agency’s customers receiving
PLR-103012-21 3

the LSL Replacements will have no obligation to repay the Agency for any costs relating
to the LSL Replacement. The Agency will not impose special charges on those
customers who receive an LSL Replacement. Instead, the Agency will use the rates
and charges that it imposes on all of its customers to pay for the costs of replacing the
LSLs and other aspects of the LRPP, including the debt service on the Bonds
(described below).

The Agency can modify its rates at any time, without oversight by the State’s public
utilities oversight authority or any other State agency. The Agency reviews and updates
its financial plan at least annually to ensure revenue is sufficient to meet expenditures.

The Agency issued the Bonds on Date 3 to finance or refinance certain capital
improvements to the Agency’s water system and the costs of replacing the LSLs. The
Agency expects that private business use (as defined in § 141(b)(6)) of the LSL
replacements likely will cause the Bonds to satisfy the private business use test of
§ 141(b)(1). No other assets financed by the Bonds will be used for a private business
use.

The Bonds are payable from and secured by the Agency’s net revenue, which consists
of its gross revenue minus operating and maintenance expenses. The Agency’s gross
revenue includes all income and revenues from the operation and use of its system.
The Agency has determined that z percent, a percentage that does not exceed 10
percent, of the debt service on the Bonds will be derived from payments that are both
received from customers that are private business users of LSL Replacements and
attributable to the costs of replacing the LSLs.

Law and Analysis

Section 103(a) provides that, except as provided in § 103(b), gross income does not
include interest on any state or local bond.

Section 103(b)(1) provides that § 103(a) shall not apply to any private activity bond
which is not a qualified bond (within the meaning of § 141).

Section 141(a) provides that the term “private activity bond” means any bond issued as
part of an issue (1) which meets (A) the private business use test of § 141(b)(1), and (B)
the private security or payment test of § 141(b)(2), or (2) which meets the private loan
financing test of § 141(c).

Section 141(b)(1) provides that, except as otherwise provided in § 141(b)(1), an issue
meets the test of § 141(b)(1) if more than 10 percent of the proceeds of the issue are to
be used for any private business use.

Section 141(b)(2) provides that, except as otherwise provided in § 141(b)(2), an issue
meets the private security or payment test if the payment of the principal of, or the
PLR-103012-21 4

interest on, more than 10 percent of the proceeds of such issue is (under the terms of
such issue or any underlying arrangement) directly or indirectly (A) secured by any
interest in (i) property used or to be used for a private business use, or (ii) payments in
respect of such property, or (B) to be derived from payments (whether or not to the
issuer) in respect of property, or borrowed money, used or to be used for a private
business use.

Section 1.141-4(a)(1) provides that the private security or payment test relates to the
nature of the security for, and the source of, the payment of debt service on an issue.
The private payment portion of the test takes into account the payment of the debt
service on the issue that is directly or indirectly to be derived from payments (whether or
not to the issuer or any related party) in respect of property, or borrowed money, used
or to be used for a private business use. The private security portion of the test takes
into account the payment of the debt service on the issue that is directly or indirectly,
secured by any interest in property used or to be used for a private business use or
payments in respect of property used to be used for a private business use.

Section 1.141-4(a)(2) provides that, for purposes of the private security or payment test,
payments taken into account as private payments and payments or property taken into
account as private security are aggregated. However, the same payments are not
taken into account as both private security and private payments.

Section 1.141-4(c)(2)(i)(A) provides that both direct and indirect payments made by any
nongovernmental person that is treated as using proceeds of the issue are taken into
account as private payments to the extent allocable to the proceeds used by that
person. Payments are taken into account as private payments only to the extent that
they are made for the period of time that proceeds are used for a private business use.
Payments for a use of proceeds include payments (whether or not to the issuer) in
respect of property financed (directly or indirectly) with those proceeds, even if not
made by a private business user. Payments are not made in respect of financed
property if those payments are directly allocable to other property being directly used by
the person making the payment and those payments represent fair market value
compensation for that other use.

Section 1.141-4(d)(4) provides that property used or to be used for a private business
use and payments in respect of that property are treated as private security if any
interest in that property or payments secures the payment of debt service on the bonds.
For this purpose, the phrase any interest in is to be interpreted broadly and includes, for
example, any right, claim, title, or legal share in property or payments.

Section 1.141-4(d)(5) provides that payments taken into account as private security are
payments in respect of property used or to be used for a private business use. Except
as otherwise provided in § 1.141-4(d)(5) and (d)(6), the rules in § 1.141-4(c)(2)(i)(A) and
(B) and (c)(2)(ii) apply to determine the amount of payments treated as payments in
respect of property used or to be used for a private business use.
PLR-103012-21 5

The source of the payments of and security for the debt service on the Bonds is the net
revenue of the Agency. The net revenue includes the rates and charges paid by the
Agency’s customers. The rates and charges imposed on all of the Agency’s customers
will pay for the costs of replacing the LSLs.

The Agency argues that no payments from its customers should count as private
payments or security because those payments are payments solely for water service.
However, it is clear that a portion of the customers’ payments of rates and charges,
which provide the payments of and security for the debt service on the Bonds, is in
respect of the LSL Replacements. Thus, we must analyze these payments under the
private security or payment test.

The customers served by the Agency include (1) customers that do not receive LSL
Replacements, (2) customers that receive LSL Replacements and that are not business
users, and (3) customers that receive LSL Replacements and that are private business
users. Payments by customers that do not receive LSL Replacements are not private
payments or security because, under § 1.141-4(c)(2)(i)(A) and (d)(5), payments are
taken into account as private payments or security only to the extent allocable to
proceeds used by that payor for a period of time that the proceeds are used for a private
business use. These customers are not using LSL Replacements and therefore, not
using proceeds of the Bonds that financed the LSL Replacements.

Payments by customers that receive LSL Replacements and that are not business
users are not private payments or security. Although these customers are users of LSL
Replacements and thus of proceeds, the proceeds used by these customers are not
used for a private business use and therefore, are not taken into account as private
payments or security.

Payments by customers that receive LSL Replacements and that are private business
users are, in part, private payments and security for the Bonds. These customers are
users of the proceeds of the Bonds and those proceeds are used in a private business
use. Customer payments, however, include amounts attributable to the Agency’s
delivery of water service as well as amounts attributable to the costs of replacing the
LSLs. The amounts received from this group of customers that are attributable to
replacing the LSLs are taken into account as private payments or security. The Agency
has determined that z percent, a percentage that does not exceed 10 percent, of the
debt service on the Bonds will be derived from payments that are both received from
customers that are private business users of LSL Replacements and attributable to the
costs of replacing the LSLs.

Conclusion

Accordingly, because the payments that are both received from customers that are
private business users of LSL Replacements and attributable to the costs of replacing
PLR-103012-21 6

the LSLs do not exceed 10 percent of the debt service on the Bonds, the Bonds will not
meet the private security or payment test.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any transaction or item discussed or referenced in this letter.
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

In accordance with a Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

The ruling contained in this letter is based upon information and representations
submitted by the Agency and accompanied by penalty of perjury statements executed
by the appropriate parties. While this office has not verified any of the materials
submitted in support of the request for a ruling, they are subject to verification upon
examination.

                                       Sincerely,
                                       Associate Chief Counsel
                                       (Financial Institutions and Products)




                                       Johanna Som de Cerff
                                       Senior Technical Reviewer, Branch 5

cc: