i.3.2.2 Legal Responsibilities Under the Internal Revenue Code
State and local governments receive direct and indirect benefits under Section 103 of the Internal Revenue Code of 1986 as amended (Tax Code) by being able to issue debt that is tax exempt. See Chapter 4 – Federal and State Tax Law Requirements. This means that purchasers of the debt generally do not pay taxes on the income received in the form of interest payments. California also exempts income earned on California state and local bonds from state tax obligations. Because investors do not pay taxes on the interest income from holding municipal debt they are willing to accept a lower interest rate. A lower interest rate results in lower cost of funds for the public agency. In compensation for state and federal governments relinquishing some amount of tax revenues by providing public debt this tax advantage, the Tax Code imposes requirements on issuers. These include the requirements imposed by the Internal Revenue Service (IRS) on the issuance of debt, the investment of proceeds from the sale of debt, the time period during which the debt may be outstanding and the proceeds unspent, and the use of property and facilities paid for with the debt. State and local governments that issue tax exempt debt must create procedures to monitor compliance with these requirements throughout the life of the bonds.
State and local agencies may issue debt and direct part or all of the proceeds to benefit a nongovernmental entity. Debt issued for this purpose is termed a “private activity” bond and is subject to additional requirements. Issuers must determine whether their debt is a private activity bond both at the time of issuance and through the full term of the debt obligation. The determination, which is discussed in more detail in Chapter 4 – Federal and State Tax Law Requirements, is based on several tests concerning the nongovernmental entity’s benefit received from the activities or facilities financed with the proceeds of the debt.
Issuers who fail to comply with the Tax Code requirements may be subject to an adverse ruling revoking the tax exemption of the bonds if examined by the IRS. Barring the issuer’s ability to negotiate a settlement with the IRS that reinstates or maintains the debt’s tax exempt status, revoking the tax exemption will likely incite investors to sue the issuer for damages suffered.16