Challenging IRS Limits on the Use of Tax-Exempt Bonds in Indian Country
August 13, 2008
By: Peter J. Kulick
I. Introduction
Over the past decade the Internal Revenue Service ("IRS") has challenged the ability of federally recognized Indian tribes to issue tax-exempt bonds to finance economic development projects. The ability of Indian tribes to access the tax-exempt financing market directly impacts the gaming industry. More generally, the gaming industry has increasingly become a part of the wider entertainment and recreation industry. Recent casino developments have incorporated high-end stores, restaurants, spas, and other entertainment and recreational activities in addition to casino gambling. In addition, access to tax-exempt markets has served, and may yet in the future serve, as a means for Indian tribes to finance the costs of facilities which complement casinos, such as hotels, golf courses and theatre venues.
Two recent developments have placed the question of whether Indian tribes may use tax-exempt bonds to pay for the costs of recreational projects at the forefront of federal tax policy related to Indian tribes. First, the Agua Caliente Band of Cahuilla Indians ("Agua Caliente Tribe") disclosed in federal securities filings that it is appealing an adverse determination by the IRS to deny the exclusion of interest, under the Internal Revenue Code of 1986, as amended ("IRC"), on $22.5 million of bonds issued in 2003(1). Second, the United States Senate Finance Committee held a hearing on July 22, 2008 regarding federal tax issues related to Indian tribes and tribe members in an effort to help develop economic development incentives for Indian Country. This article discusses the recent developments and provides an overview of the current state of the federal tax law. The recent developments may very well improve Indian tribes' flexibility and ability to access the tax-exempt financing markets.
II. The Agua Caliente Tribe IRS Appeal
The Agua Caliente Tribe issued approximately $22.5 million of tax-exempt bonds in 2003(2). The tribal bonds were issued to finance the renovation and expansion of the Canyon South Golf Course and related facilities located in Palm Springs, California(3). The Canyon South Golf Course is operated by the Agua Caliente Tribe(4). The Agua Caliente Tribe also operates the nearby Agua Caliente Casino and resort complex. The 2003 bond issue was the subject of a noteworthy IRS field service advice(5). In a lengthy discussion, the IRS Chief Counsel's office cautioned that, "[b]ecause of what we see as substantial litigation hazards,...we would not recommend litigating the issue of whether interest on the [Agua Caliente Tribe's] Bonds is excluded from gross income under [IRC] § 103 on these facts."(6) The crux of the legal issue of the Agua Caliente Tribe's 2003 bond issue centers on the differing standard for the exclusion of interest under the IRC for bonds issued by Indian tribes compared to bonds issued by state and local governments.
A. The Source of Tax-Exemption for Bonds Issued by Indian Tribes: IRC § 7871
IRC § 103 generally provides that interest paid on bonds issued by state or local governments is excluded from gross income. Indian tribes are not defined as a "State or local government" for purposes of IRC § 103(7). Rather, an Indian tribe may be treated as a state for purposes of IRC § 103 by virtue of other provisions of the IRC(8). An Indian tribe may issue tax-exempt bonds in two circumstances(9). Relevant to the bonds issued by the Agua Caliente Tribe, bonds issued by an Indian tribe may qualify for exclusion of interest under IRC § 103 "if such obligation is part of an issue substantially all of the proceeds of which are used in the exercise of any essential governmental function."(10) "Essential governmental function" is further defined by IRC § 7871(e) as "not includ[ing] any function which is not customarily performed by State or local governments with general taxing powers."
The authority to issue tribal bonds differs from the authority of states to issue tax-exempt bonds. "The power of States to issue tax-exempt bonds...is not conditioned upon the exercise of an essential governmental function, although activities of State governments are generally limited by State Constitutions or statutes. These limitations on State activities may be less stringent than the essential government function limitation applicable to Indian tribes."(11) Thus, the issue in the Agua Caliente Tribe appeal -- and more generally with regard to other tribal bonds -- is whether the bonds are issued for an essential governmental function.
B. The Dispute Over the Meaning of "Essential Government Function"
At the outset, IRC § 7871(e) limits the definition of "essential government function" by providing that the term "shall not include any function which is not customarily performed by State and local governments with general taxing powers."(12) FSA 20024712 applied a two-step inquiry to determine whether an activity is an essential governmental function: (1) whether the activity is a general function that is performed at multiple levels of government or is so specialized that it is only performed by one type of state or local government; and (2) the degree of prevalence of the function within those jurisdictions where the function is generally performed.
In applying the two-step analysis, the IRS noted that "it is probable that a court, faced with this fairly common activity [of owning and operating golf courses] of state or local governments, and taking into account the interpretative standard accorded Tribal governments, would conclude that the Golf Course meets the statutory standard for an essential governmental function."(13) The lengthy discussion of the litigation hazards in FSA 20024712 is persuasive authority, together with other IRS authorities, which may be indicative of the ultimate result if the matter is litigated.
First, as noted in FSA 20024712, based on subsequent congressional modification to the Treasury Regulations promulgated under IRC § 7871, "the only question...may be whether the activity being financed is a customary activity of state or local governments." FSA 20024712 noted that there are a large number of golf courses which are own and operated by state and local governments. As a result, the Chief Counsel concluded "that it would be difficult to argue" that the Agua Caliente Tribe's golf course was too commercial in nature so that a state or local government would not own and operate a similar project.(14) Thus, by examining similar activities of state and local governments, there is strong factual support to conclude that the operation of a golf course is an essential governmental function.
Second, private letter rulings in other analogous areas of federal tax law are consistent with the proposition that the operation of golf courses, and other recreational facilities, is an essential governmental function. For example, an exempt activity for purposes of IRC § 501(c)(3) includes activities which lessen the burdens of government.(15) The standard for lessening the burdens of government implicates a similar analysis as whether an activity is an essential government function. That is, under the lessening the burdens of government standard, an activity must be one which a governmental unit considers to be its burden. In PLR 20014057 (July 17, 2001), the IRS concluded that an exempt organization's operation of a golf course and marina qualified as an activity which lessened the burdens of government. Accordingly, the IRS' analysis under the lessening the burden of government standard provides some support to argue that such activities are analogous to essential governmental functions. That is, if an activity can be one which a government considers its burden, then the activity should similarly be viewed as an essential governmental function or, at least, offer persuasive authority of activities which could be essential governmental functions.
Despite acknowledging the significant litigation hazards -- and even recommending against litigating the issue -- the IRS Chief Counsel Office still offered a theory to deny the exclusion of interest for the Agua Caliente Tribe's 2003 bond issue. In FSA 20024712, the IRS advanced the argument that "[t]he legislative history of [IRC] § 7871(e) indicates that Congress meant not to include commercial or industrial facilities as essential governmental functions even if such functions were commonly financed with tax-exempt bonds by state or local governments." Thus, the IRS concluded that an argument could be made that the Agua Caliente Tribe could not finance its South Canyon Golf Course project with tax-exempt bonds because it was a commercial enterprise.(16) The genesis of the argument, according to some commentators, is that the IRS views the Aqua Caliente Tribe's golf course as too upscale and too commercial to be analogous to the typical municipally owned golf course.(17)
III. Recent Legislative Developments
Recent efforts in Congress may also yield significant benefits to Indian Country in the form of easing the IRS's restrictive view of the types of projects which may be financed on a tax-exempt basis by Indian tribes. The July 22, 2008 hearings before the United States Senate Finance Committee were designed to examine policy methods to increase economic development projects in Indian tribal communities.
Wayne Shammel, general counsel to the Cow Creek Band of Umpqua Tribe of Indians and a long-time client of Dickinson Wright attorney Dennis Whittlesey, offered testimony which identified the barriers Indian tribes experience to access tax-exempt financing markets under the current federal tax law. Mr. Shammel identified three provisions of current federal tax law that apply only to tribal government bond offerings: "(1) the 'essential governmental function' test; (2) the general prohibition on private activity bonds; and (3) the limited exception for tribal manufacturing facilities."(18) Mr. Shammel offered several recommendations to improve tribal governments' access to tax-exempt financing, which include repealing the "essential governmental functions" test, equalizing federal securities exemptions for Indian tribes offering bonds, and increasing tribes' ability to issue private activity bonds.(19) The Senate Finance Committee hearing coincides with the introduction of legislation by Committee Chairman, Senator Max Bacaus, to increase the flexibility of Indian tribes to issue tax-exempt bonds.
IV. Conclusion
The recent legal developments concerning Indian tribes' ability to issue tax-exempt bonds may greatly enhance tribes' ability to tap into the tax-exempt financing markets. Offering greater access should, more generally, encourage more economic development projects in Indian Country and may also impact the gaming industry by offering Indian tribes more flexibility to finance the costs of recreational facilities which complement casinos. Ultimately, the Agua Caliente Tribe's appeal of the determination of the IRS to deny the exclusion of interest paid on the tribe's bonds under IRC ? 103 may end up in court. The Chief Counsel's analysis of the term "essential governmental function" in FSA 20024712, together with other authorities, is suggestive that the Agua Caliente Tribe may prevail. The result would be a significant victory for Indian Country which may offer greater flexibility and access to the tax-exempt financing markets. Similarly, even more flexibility may be available to Indian tribes if Congress enacts any of the recommendations offered during the recent Senate Finance Committee hearings.
_______________________________________________________________
1. See "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008).
2. See "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008).
3. See id.
4. Id.
5. FSA 20024712 (Nov. 11, 2002).
6. Id.
7. See § 103(c); and Treas. Reg. § 1.103-1.
8. IRC § 7871(a)(4) provides that "[a]n Indian tribal government shall be treated as a State - (4) for purposes of section 103 (relating to state and local bonds)."
9. The second circumstance when an Indian tribe may issue tax-exempt bonds involves the issuance of bonds known as "private activity bonds" which meet certain requirements. See IRC § 7871(c)(3). Private activity bonds issued under the narrow scope of IRC § 7871(c)(3) are bonds issued by Indian tribes to finance certain manufacturing projects. The ability to issue private activity bonds under IRC § 7871(c)(3) was not implicated with respect to the Aqua Caliente Tribe's bonds.
10. IRC § 7871(c)(1) (emphasis added).
11. Joint Committee on Taxation, Overview of Federal Tax Provisions Relating to Native American Tribes and Their Members (JCX-61-08) (July 18, 2008).
12. IRC § 7871(e).
13. FSA 20024712.
14. See id.
15. For purposes of IRC § 501(c)(3), an activity is considered to lessen the burdens of government when two conditions are met.
First, a governmental unit must consider the organization's activities to be its burden. Second, these activities must actually lessen the burden of the governmental unit. An activity is a burden of government if there is an objective manifestation by the governmental unit that it considers the activities of the organization to be its burden. The interrelationship between the governmental unit and the organization may provide evidence that the governmental unit considers the activity to be its burden. Whether the organization is actually lessening the burdens of government is determined by considering all of the relevant facts and circumstances.
PLR 20014057 (citing Rev. Rul. 85-1).
16. See id.
17. See, e.g., "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008). See also FSA 20024712 where the Chief Counsel's office noted that the facts of the Aqua Caliente Tribe's bond issues represented an "extreme case" which may support advancing the argument that the bonds are not issued for a customary essential governmental function.
18. Indian Governments and the Tax Code: Maximizing Tax Incentives for Economic Development Before Senate Comm. on Finance, 110th Cong. (2008) (statement of Wayne Shammel, Esq., Cow Greek Band of Umpqua Tribe of Indians), available at: http://finance.senate.gov/hearings/testimony/2008test/072208wstest.pdf
19. Id.
I. Introduction
Over the past decade the Internal Revenue Service ("IRS") has challenged the ability of federally recognized Indian tribes to issue tax-exempt bonds to finance economic development projects. The ability of Indian tribes to access the tax-exempt financing market directly impacts the gaming industry. More generally, the gaming industry has increasingly become a part of the wider entertainment and recreation industry. Recent casino developments have incorporated high-end stores, restaurants, spas, and other entertainment and recreational activities in addition to casino gambling. In addition, access to tax-exempt markets has served, and may yet in the future serve, as a means for Indian tribes to finance the costs of facilities which complement casinos, such as hotels, golf courses and theatre venues.
Two recent developments have placed the question of whether Indian tribes may use tax-exempt bonds to pay for the costs of recreational projects at the forefront of federal tax policy related to Indian tribes. First, the Agua Caliente Band of Cahuilla Indians ("Agua Caliente Tribe") disclosed in federal securities filings that it is appealing an adverse determination by the IRS to deny the exclusion of interest, under the Internal Revenue Code of 1986, as amended ("IRC"), on $22.5 million of bonds issued in 2003(1). Second, the United States Senate Finance Committee held a hearing on July 22, 2008 regarding federal tax issues related to Indian tribes and tribe members in an effort to help develop economic development incentives for Indian Country. This article discusses the recent developments and provides an overview of the current state of the federal tax law. The recent developments may very well improve Indian tribes' flexibility and ability to access the tax-exempt financing markets.
II. The Agua Caliente Tribe IRS Appeal
The Agua Caliente Tribe issued approximately $22.5 million of tax-exempt bonds in 2003(2). The tribal bonds were issued to finance the renovation and expansion of the Canyon South Golf Course and related facilities located in Palm Springs, California(3). The Canyon South Golf Course is operated by the Agua Caliente Tribe(4). The Agua Caliente Tribe also operates the nearby Agua Caliente Casino and resort complex. The 2003 bond issue was the subject of a noteworthy IRS field service advice(5). In a lengthy discussion, the IRS Chief Counsel's office cautioned that, "[b]ecause of what we see as substantial litigation hazards,...we would not recommend litigating the issue of whether interest on the [Agua Caliente Tribe's] Bonds is excluded from gross income under [IRC] § 103 on these facts."(6) The crux of the legal issue of the Agua Caliente Tribe's 2003 bond issue centers on the differing standard for the exclusion of interest under the IRC for bonds issued by Indian tribes compared to bonds issued by state and local governments.
A. The Source of Tax-Exemption for Bonds Issued by Indian Tribes: IRC § 7871
IRC § 103 generally provides that interest paid on bonds issued by state or local governments is excluded from gross income. Indian tribes are not defined as a "State or local government" for purposes of IRC § 103(7). Rather, an Indian tribe may be treated as a state for purposes of IRC § 103 by virtue of other provisions of the IRC(8). An Indian tribe may issue tax-exempt bonds in two circumstances(9). Relevant to the bonds issued by the Agua Caliente Tribe, bonds issued by an Indian tribe may qualify for exclusion of interest under IRC § 103 "if such obligation is part of an issue substantially all of the proceeds of which are used in the exercise of any essential governmental function."(10) "Essential governmental function" is further defined by IRC § 7871(e) as "not includ[ing] any function which is not customarily performed by State or local governments with general taxing powers."
The authority to issue tribal bonds differs from the authority of states to issue tax-exempt bonds. "The power of States to issue tax-exempt bonds...is not conditioned upon the exercise of an essential governmental function, although activities of State governments are generally limited by State Constitutions or statutes. These limitations on State activities may be less stringent than the essential government function limitation applicable to Indian tribes."(11) Thus, the issue in the Agua Caliente Tribe appeal -- and more generally with regard to other tribal bonds -- is whether the bonds are issued for an essential governmental function.
B. The Dispute Over the Meaning of "Essential Government Function"
At the outset, IRC § 7871(e) limits the definition of "essential government function" by providing that the term "shall not include any function which is not customarily performed by State and local governments with general taxing powers."(12) FSA 20024712 applied a two-step inquiry to determine whether an activity is an essential governmental function: (1) whether the activity is a general function that is performed at multiple levels of government or is so specialized that it is only performed by one type of state or local government; and (2) the degree of prevalence of the function within those jurisdictions where the function is generally performed.
In applying the two-step analysis, the IRS noted that "it is probable that a court, faced with this fairly common activity [of owning and operating golf courses] of state or local governments, and taking into account the interpretative standard accorded Tribal governments, would conclude that the Golf Course meets the statutory standard for an essential governmental function."(13) The lengthy discussion of the litigation hazards in FSA 20024712 is persuasive authority, together with other IRS authorities, which may be indicative of the ultimate result if the matter is litigated.
First, as noted in FSA 20024712, based on subsequent congressional modification to the Treasury Regulations promulgated under IRC § 7871, "the only question...may be whether the activity being financed is a customary activity of state or local governments." FSA 20024712 noted that there are a large number of golf courses which are own and operated by state and local governments. As a result, the Chief Counsel concluded "that it would be difficult to argue" that the Agua Caliente Tribe's golf course was too commercial in nature so that a state or local government would not own and operate a similar project.(14) Thus, by examining similar activities of state and local governments, there is strong factual support to conclude that the operation of a golf course is an essential governmental function.
Second, private letter rulings in other analogous areas of federal tax law are consistent with the proposition that the operation of golf courses, and other recreational facilities, is an essential governmental function. For example, an exempt activity for purposes of IRC § 501(c)(3) includes activities which lessen the burdens of government.(15) The standard for lessening the burdens of government implicates a similar analysis as whether an activity is an essential government function. That is, under the lessening the burdens of government standard, an activity must be one which a governmental unit considers to be its burden. In PLR 20014057 (July 17, 2001), the IRS concluded that an exempt organization's operation of a golf course and marina qualified as an activity which lessened the burdens of government. Accordingly, the IRS' analysis under the lessening the burden of government standard provides some support to argue that such activities are analogous to essential governmental functions. That is, if an activity can be one which a government considers its burden, then the activity should similarly be viewed as an essential governmental function or, at least, offer persuasive authority of activities which could be essential governmental functions.
Despite acknowledging the significant litigation hazards -- and even recommending against litigating the issue -- the IRS Chief Counsel Office still offered a theory to deny the exclusion of interest for the Agua Caliente Tribe's 2003 bond issue. In FSA 20024712, the IRS advanced the argument that "[t]he legislative history of [IRC] § 7871(e) indicates that Congress meant not to include commercial or industrial facilities as essential governmental functions even if such functions were commonly financed with tax-exempt bonds by state or local governments." Thus, the IRS concluded that an argument could be made that the Agua Caliente Tribe could not finance its South Canyon Golf Course project with tax-exempt bonds because it was a commercial enterprise.(16) The genesis of the argument, according to some commentators, is that the IRS views the Aqua Caliente Tribe's golf course as too upscale and too commercial to be analogous to the typical municipally owned golf course.(17)
III. Recent Legislative Developments
Recent efforts in Congress may also yield significant benefits to Indian Country in the form of easing the IRS's restrictive view of the types of projects which may be financed on a tax-exempt basis by Indian tribes. The July 22, 2008 hearings before the United States Senate Finance Committee were designed to examine policy methods to increase economic development projects in Indian tribal communities.
Wayne Shammel, general counsel to the Cow Creek Band of Umpqua Tribe of Indians and a long-time client of Dickinson Wright attorney Dennis Whittlesey, offered testimony which identified the barriers Indian tribes experience to access tax-exempt financing markets under the current federal tax law. Mr. Shammel identified three provisions of current federal tax law that apply only to tribal government bond offerings: "(1) the 'essential governmental function' test; (2) the general prohibition on private activity bonds; and (3) the limited exception for tribal manufacturing facilities."(18) Mr. Shammel offered several recommendations to improve tribal governments' access to tax-exempt financing, which include repealing the "essential governmental functions" test, equalizing federal securities exemptions for Indian tribes offering bonds, and increasing tribes' ability to issue private activity bonds.(19) The Senate Finance Committee hearing coincides with the introduction of legislation by Committee Chairman, Senator Max Bacaus, to increase the flexibility of Indian tribes to issue tax-exempt bonds.
IV. Conclusion
The recent legal developments concerning Indian tribes' ability to issue tax-exempt bonds may greatly enhance tribes' ability to tap into the tax-exempt financing markets. Offering greater access should, more generally, encourage more economic development projects in Indian Country and may also impact the gaming industry by offering Indian tribes more flexibility to finance the costs of recreational facilities which complement casinos. Ultimately, the Agua Caliente Tribe's appeal of the determination of the IRS to deny the exclusion of interest paid on the tribe's bonds under IRC ? 103 may end up in court. The Chief Counsel's analysis of the term "essential governmental function" in FSA 20024712, together with other authorities, is suggestive that the Agua Caliente Tribe may prevail. The result would be a significant victory for Indian Country which may offer greater flexibility and access to the tax-exempt financing markets. Similarly, even more flexibility may be available to Indian tribes if Congress enacts any of the recommendations offered during the recent Senate Finance Committee hearings.
_______________________________________________________________
1. See "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008).
2. See "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008).
3. See id.
4. Id.
5. FSA 20024712 (Nov. 11, 2002).
6. Id.
7. See § 103(c); and Treas. Reg. § 1.103-1.
8. IRC § 7871(a)(4) provides that "[a]n Indian tribal government shall be treated as a State - (4) for purposes of section 103 (relating to state and local bonds)."
9. The second circumstance when an Indian tribe may issue tax-exempt bonds involves the issuance of bonds known as "private activity bonds" which meet certain requirements. See IRC § 7871(c)(3). Private activity bonds issued under the narrow scope of IRC § 7871(c)(3) are bonds issued by Indian tribes to finance certain manufacturing projects. The ability to issue private activity bonds under IRC § 7871(c)(3) was not implicated with respect to the Aqua Caliente Tribe's bonds.
10. IRC § 7871(c)(1) (emphasis added).
11. Joint Committee on Taxation, Overview of Federal Tax Provisions Relating to Native American Tribes and Their Members (JCX-61-08) (July 18, 2008).
12. IRC § 7871(e).
13. FSA 20024712.
14. See id.
15. For purposes of IRC § 501(c)(3), an activity is considered to lessen the burdens of government when two conditions are met.
First, a governmental unit must consider the organization's activities to be its burden. Second, these activities must actually lessen the burden of the governmental unit. An activity is a burden of government if there is an objective manifestation by the governmental unit that it considers the activities of the organization to be its burden. The interrelationship between the governmental unit and the organization may provide evidence that the governmental unit considers the activity to be its burden. Whether the organization is actually lessening the burdens of government is determined by considering all of the relevant facts and circumstances.
PLR 20014057 (citing Rev. Rul. 85-1).
16. See id.
17. See, e.g., "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008). See also FSA 20024712 where the Chief Counsel's office noted that the facts of the Aqua Caliente Tribe's bond issues represented an "extreme case" which may support advancing the argument that the bonds are not issued for a customary essential governmental function.
18. Indian Governments and the Tax Code: Maximizing Tax Incentives for Economic Development Before Senate Comm. on Finance, 110th Cong. (2008) (statement of Wayne Shammel, Esq., Cow Greek Band of Umpqua Tribe of Indians), available at: http://finance.senate.gov/hearings/testimony/2008test/072208wstest.pdf
19. Id.