4.6.2 Private Security or Payment Test
The Private Security or Payment Test is the second part of the Private Activity Bond Tests. Both the Private Business Use Test and Private Security or Payment Test must be satisfied for a bond to be a private activity bond. In other words, a bond can qualify as a tax exempt governmental bond if the Private Business Use Test is met, or if the Private Security or Payment Test is met, but not if both tests are met. In certain bond structures, it is clear that one of the tests will be met, and the tax analysis for the bonds will focus on ensuring that the other test is not met. For example, as described below, tax assessment bonds will generally meet the Private Security or Payment Test, and as a result, it is necessary to ensure that these bonds do not meet the Private Business Use Test.
As its name implies, the Private Security or Payment Test looks at the source of the monies paid toward debt service (directly or indirectly) and the security provided for the bonds by nongovernmental persons. The Private Security or Payment Test is met if the aggregate present value of the private payments and private security exceeds 10% of the present value of the debt service on the bonds, with certain adjustments. Present values are computed using the yield on the bonds as a discount rate.
For purposes of the Private Payment or Security Test, the Regulations provide that generally applicable taxes imposed at a uniform rate and applied to all persons of the same classification in the jurisdiction are not taken into account. For example, ad valorem property taxes are generally applicable taxes, and will not be treated as private payments or private security. In addition, it is possible to structure certain arrangements with payments in lieu of taxes or “PILOTs”, which will be treated as generally applicable taxes and therefore not as private payments or private security. However, in general, real property assessments, Mello Roos special taxes, and other payments for a special privilege granted or service rendered are not generally applicable taxes and instead would be treated as private payments or private security. As a result, bonds secured by such assessments, taxes, or payments generally must be used for projects that do not meet the Private Business Use Test in order to be issued as tax exempt bonds.
PRIVATE SECURITY – The Regulations provide only limited guidance in interpreting the private security provisions of the Private Payment or Security Test. In general, to the extent that property is pledged as security for the payment of debt service on the bonds, and that property is either (1) financed with proceeds of the bonds and used for any private business use, or (2) provided by a non governmental user of proceeds of the bonds (or assets financed by the bonds), the property will result in private security. For purposes of valuing the property to determine the amount of private security, property used by non governmental persons is to be valued at its fair market value (rather than its historical cost) as of the date when the property first secures the bonds.
PRIVATE PAYMENTS – In general, the Regulations consider all payments to the issuer or to any related entity by any non governmental person that uses the bond proceeds or bond financed facilities as private payments, even if the payments are made by non governmental persons who use the property as members of the general public, to the extent the payments either (1) are to be used, directly or indirectly, to pay debt service on the bonds, or (2) are to be made for bond-financed facilities that are subject to private business use.
This is a broad definition of private payments. For example, if a bond financed hospital is managed by a non governmental person according to a contract that results in private business use (i.e., it is not a qualified management contract that fits within the safe harbor from private business use), all payments made by the public with respect to use of that hospital will be treated as private payments. Because of this broad definition of private payments, the tax analysis for tax exempt bonds often focuses primarily on ensuring that the Private Business Use Test is not met. There are some exclusions for amounts that might otherwise be treated as private payments. The amount of the private payments is decreased by the allocable operating and maintenance expenses paid by the issuer with respect to the financed facilities. In addition, the amount of private payments is limited by the amount of private business use of a project, such that a small amount of private business use within a larger bond financed project might not require all revenues of that facility to be treated as private payments, but instead only the portion of the revenues allocable to that private business use.