On March 19, 2012 the United States Court of Appeals for the Third Circuit filed an opinion in a case involving a claim by a taxpayer that interest paid by the State of Pennsylvania under a settlement agreement reached in a condemnation case was exempt from Federal income tax under Section 103 of the Internal Revenue Code of 1986. The Court overturned the Tax Court in holding that interest payments by the State under a negotiated agreement were exempt under Section 103 since the agreement constituted an exercise of the State's borrowing power and the extension of credit, payment of interest and interest rate under the agreement were negotiated terms.
This holding seems consistent with prior decisions on the distinction between negotiated interest paid by state and local governments (which is exempt under Section 103) and statutory interest (that is, interest dictated by statute such as, for instance, pre-judgment interest). But there are several interesting questions that are never mentioned in the opinion and have significant implications.
For instance, did the State intend that the interest be exempt from Federal income taxes? These days it is not unusual for a governmental entity to borrow on a taxable basis for any one of several reasons including the market at the time, the type of project being financed, and issues with "bank qualified" bonds, as well as others. Normally, the issuer can make the determination of whether the issue is tax-exempt, although usually we like to see some affirmative act or omission to enforce that determination (such as not filing a form 8038 or 8038G which is normally required for an issue to be tax-exempt).
Here, the Court did not focus on the issuer at all but only the taxpayer, the recipient of the interest. Can the taxpayer claim the interest is tax-exempt regardless of what the issuer intends? Is tax-exemption a feature that the issuer is entitled to or that the taxpayer is entitled to? Since there is no mention of the State's intent in the opinion, it leaves these questions up in the air.
Also, there is no mention of whether the State filed an 8038G. Normally, under Section 147, interest is only tax-exempt if you complete the required filing with the IRS (as well as follow the other procedural requirements under the Code). There is no mention one way or the other in the opinion yet the interest is held to be tax-exempt. Does this suggest that interest on state and local government obligations can be tax-exempt regardless of whether the issuer follows the procedural requirements under the Code? Are state and local governments entitled under the Constitution to issue tax-exempt debt? This, of course, is a question which has fascinated bond lawyers since 1913 and the ratification of the Sixteenth Amendment authorizing the federal income tax.
My name is David VanSickel and I am a senior shareholder at the Davis Brown Law Firm. As a member of the firm's Business Division, I maintain a general practice in, but not limited to, Finance and Public Finance.