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Gardner Carton & Douglas Client Memorandum
Tax-Exempt April 2002
IRS Issues Proposed Regulations on Acquisition Financing
On Friday, April 5, 2002, the Internal Revenue Service (“IRS”) • Provide that parties to an acquisition are “affiliated
released proposed regulations (the “Proposed Regulations”) persons” if:
that address the treatment of “acquisition financing” trans-
actions. The Proposed Regulations will be published in the § At any time during the six-month period prior to the
Federal Register on April 10, 2002. affiliation transaction, more than five percent of the
voting power of one corporation is vested in the
Executive Summary other corporation and its directors, officers, and
employees; or
The Proposed Regulations:
§ At any time during either the six-month period prior
• Clarify that acquisition of a membership interest in a to the affiliation transaction or the six-month period
Section 501(c)(3) organization qualifies as an acquisi- following the affiliation transaction, action is taken
tion transaction. with respect to the composition of the board of the
acquiring corporation to reflect the representation
• Clarify that, generally, the determination of whether of the interests of the acquired corporation.
corporations are “related” is made immediately prior to
the issuance of the new bonds. Why Is Acquisition Financing Important and
• Provide that bonds issued for the benefit of an “acquir-
What Is the Tax Issue?
ing corporation” will be classified as refunding bonds if The term “acquisition financing” generally refers to a trans-
the proceeds are ultimately applied to pay or defease action in which a buyer finances the purchase of assets from
outstanding bonds of another corporation (or a related another party using tax-exempt bonds. The proceeds are
party) that has, or obtains in the transaction, the right then used by the seller to pay or defease the seller’s out-
to appoint a majority of the board of the acquiring standing tax-exempt bonds. The term is used to distinguish
corporation (or a corporation that controls the acquir- such bonds from “refunding bonds,” which are issued to en-
ing corporation). able a borrower to refinance its own outstanding bonds. The
term “acquisition financing” includes the specific situation in
• Effectively create a new category of “refinancing which the buyer assumes the seller’s bonds and subsequently
bonds” for transactions between “affiliated persons” refinances the assumed debt. It also includes hospital affilia-
that are not classified as refunding bonds, but that are tion transactions in which tax-exempt bonds are issued con-
subject to certain rules normally applicable only to temporaneously with the affiliation.
refunding bonds:
The distinction between “acquisition financing” and “refund-
§ The refinanced bonds must be called at the earliest ing bonds” is critical. Since 1986, bonds issued for the ben-
call date (regardless of premium); and efit of Section 501(c)(3) organizations can be advance re-
funded only once. An advance refunding occurs when the
§ The proceeds of the refinancing bonds must be bonds being refinanced are not redeemed within 90 days of
allocated to the same assets to which the refi- the date on which the refunding bonds are issued. Many long
nanced bonds were allocated. term fixed rate bonds have a ten-year no call period, which
means that they cannot be redeemed prior to the end of the
tenth year. When interest rates decrease, a refinancing of
Gardner Carton & Douglas
outstanding debt may be desirable. If the outstanding bonds The Proposed Regulations
are in the no call period, the only means by which to take
advantage of the lower interest rates is an advance refund- The Proposed Regulations modify the existing provisions of
ing to defease the outstanding bonds. The proceeds of the the Treasury Regulations that define the term “refunding
new bonds are placed in an escrow, which is then used to bond.” As under the current regulations, a refunding bond
pay debt service on the old bonds until the call date. The generally is defined as any bond the proceeds of which are
borrower now pays only the debt service on the new bonds – used to pay principal, interest, or premium on any other bond.
at the lower interest rate. Because an advance refunding The current regulations include two critical exceptions to this
results in two bond issues outstanding at the same time to general rule: the “change in obligor” exception and the “six-
finance a single project, the revenue loss to the federal gov- month exception.”
ernment and effective government subsidy increases. To
limit this revenue loss, Congress capped the number of per- Change in Obligor Exception. The “change in obli-
mitted advance refundings in 1986. gor” exception recognizes that a bond should not be treated
as a refunding if the borrower of the new debt is unrelated to
The ability to use acquisition financing is important for two the borrower of the old debt. For example, Hospital B uses
reasons. First, it facilitates consolidation of nonprofit hospi- tax-exempt bonds to finance the acquisition of assets from
tals and health care systems by enabling the consolidated Hospital A. Hospital A then applies some or all of the money
system to operate under a single set of financial covenants. it receives from the sale to pay or defease its outstanding
Many hospitals have outstanding advance refunding bonds. bonds. If Hospital A will have no corporate relationship with
These bonds may not themselves be advance refunded. This Hospital B post-closing (e.g., will not be a corporate mem-
restriction can pose a significant obstacle to a merger or con- ber of Hospital B and will have no right to appoint board
solidation. For example, the financial covenants imposed by members), Hospital B’s bonds would not be treated as re-
one hospital’s bonds may be inconsistent with the covenants funding bonds simply because Hospital A applied the money
imposed by the second hospital’s bonds. In some cases, with- it received as the purchase price to pay or defease its bonds.
out refinancing outstanding debt, the consolidation may not Hospital A has not refinanced its bonds; it has simply applied
be possible. In addition, it allows the consolidated system, corporate funds recognized from the sale of assets to its out-
when appropriate, to save money by financing the acquisition standing debt.
at lower interest rates. These reduced costs are consistent
with the federal government’s desire to reduce the costs of The Proposed Regulations clarify that the determination of
providing health care. Unfortunately, some of the provisions relatedness is made immediately prior to the issuance of the
of the Proposed Regulations will serve to increase costs in- new bonds. However, the Proposed Regulations also pro-
curred by nonprofit providers. vide an exclusion (previously applicable only to the six-month
exception) under which the change in obligor exception does
The key question that must be addressed in any acquisition not apply to bonds issued in connection with an affiliation
financing transaction is whether the surviving entity/buyer is transaction to which Section 381(a) applies. Section 381(a)
related to the original borrower/seller for federal income tax generally applies to transactions, such as statutory mergers,
purposes. Under existing Treasury Regulations, however, that qualify as tax-free reorganizations and certain tax-free
there is no clear guidance that governs the determination of liquidations.
whether the survivor/buyer is related to the seller in many
common types of hospital system consolidations. In the ab- Six-Month Exception. Under the existing regulations,
sence of clear guidance, law firms serving as bond counsel if a corporation assumes obligations of an unrelated party in
have developed varying approaches and analyses for deter- connection with an “acquisition transaction,” and within six-
mining whether acquisition financing is possible. months before or after the transaction the assumed issue is
refinanced, the refinancing issue is not classified as a refund-
ing. The refinancing issue would not qualify for the change
What Is the IRS’s Concern?
in obligor exception because the obligor on the new bonds
The IRS views acquisition financing in the context of hospital and the old bonds is the same. This exception recognizes
affiliations as the refinancing of outstanding tax-exempt bonds that it is not possible or practical in some transactions for the
with a second issue of tax-exempt bonds. The IRS believes new bonds to be issued contemporaneously with the acquisi-
such refinancings may overburden the tax-exempt market, tion transaction, but that the purpose for the new issue is in
undercutting the Congressional intent reflected in the restric- fact to finance the purchase of assets from an unrelated third
tions on advance refundings. party.
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Gardner Carton & Douglas
The Proposed Regulations expand the definition of “acquisi- bonds are effectively subjected to certain of the advance re-
tion transaction” to specifically include the acquisition of con- funding rules (but, importantly, not the limitation on the num-
trol of a Section 501(c)(3) organization through the acquisi- ber of advance refundings).
tion of stock, membership interests, or otherwise. Although
it is helpful that the IRS has clarified that membership acqui- Most hospital affiliation transactions will result in the parties
sitions qualify, state law in some instances prohibits the sale being classified as “affiliated persons” under the broad defi-
of membership interests. nition in the Proposed Regulations. The Proposed Regula-
tions provide that two corporations are affiliated persons if
Related Persons. To determine whether the change in either: (1) at any time during the six-month period prior to
obligor or six-month exceptions apply, it is necessary to de- the affiliation transaction, more than five percent of the vot-
termine if the borrower of the new debt is related to the bor- ing power of one corporation is vested in the other corpora-
rower of the old debt. The Proposed Regulations provide tion and its directors, officers, and employees; or (2) at any
helpful clarification on this issue but also impose significant time during either the six-month period prior to the affiliation
new requirements that will apply to the issuance of tax-ex- transaction or the six-month period following the affiliation
empt bonds in certain hospital affiliation transactions. transaction, the composition of the governing board of the
acquiring corporation (or any person that controls the acquir-
The Proposed Regulations do not modify the existing provi- ing corporation) is established or modified to reflect (directly
sions defining the term “related party.” However, the addi- or indirectly) representation of the interests of the acquired
tion of an example involving a common form of hospital af- corporation or the corporation from which the assets are ac-
filiation transaction provides useful clarification of how the quired. Thus, in the example discussed above, both Hospital A
IRS will apply that definition. In the new example, Hospital A and Hospital B are “affiliated persons” with respect
and Hospital B form a new entity, Corporation C. Hospital A Corporation C because within the relevant one-year period,
and Hospital B each appointed one-half of the governing board Corporation C’s board was established in a manner that re-
of Corporation C. Corporation C then uses tax-exempt bonds flects representation of the interests of Hospital A (which
to acquire the sole membership interests in Hospital A and appointed 50% of Corporation C’s initial board) and of
Hospital B. The proceeds from the sale of the membership Hospital B (which also appointed 50% of Corporation C’s
interests are ultimately used to defease Hospital A’s and initial board). Under this broad definition, representation by
Hospital B’s outstanding bonds. The example states that even one board position will create the “affiliated persons”
Corporation C is not a related party to Hospital A or Hospital B relationship.
immediately prior to the issuance of the Corporation C bonds,
confirming that actual majority control (i.e., more than 50%) The Proposed Regulations also effectively expand the defi-
is required. Thus, under the general provisions of the “change nition of “related party” and limit the definition of “acquisition
in obligor” exception, Corporation C’s bonds would not be transaction” by providing specific rules for certain “reverse
treated as refunding bonds and, therefore, would not be sub- acquisitions.” Under these new provisions, bonds issued for
ject to the rules applicable to advance refunding bonds. How- the benefit of an acquiring corporation and ultimately applied
ever, the Corporation C bonds will be subject to the new re- to pay or defease outstanding bonds will be classified as re-
strictions imposed by the Proposed Regulations on “refinancing funding bonds if the borrower of the outstanding bonds (or a
bonds” involving “affiliated persons,” discussed below. related person) has, or obtains in the affiliation transaction,
the right to appoint the majority of the members of the gov-
Although the Proposed Regulations do not directly modify erning board of the acquiring corporation.
the definition of “related party,” they effectively expand the
definition to include “affiliated persons” unless certain re- Conclusion
quirements are satisfied. The Proposed Regulations provide
that the “change in obligor” and “six-month” exceptions will While it is helpful that the IRS has finally published Proposed
not apply to any “refinancing bonds” issued in connection Regulations setting forth bright lines for acquisition financing,
with a transaction between affiliated persons unless (1) the it is disappointing that certain affiliations that do not involve
refinanced bonds are redeemed on the earliest call date or transactions between related parties will be subject to re-
within 90 days of the issuance of the refinancing bonds (thus strictions that may increase the costs of consolidations by
potentially requiring the payment of a redemption premium); nonprofit health care providers and ultimately may hinder in-
and (2) the refinancing issue is treated as financing the as- stitutional providers in their attempts to reduce the cost of
sets that were financed with the original issue. Thus, to avoid health care.
classification as advance refunding bonds, the refinancing
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Gardner Carton & Douglas
For more information on the IRS proposed regulations on acquisition financing, please contact the authors of this
client memorandum (T.J. Sullivan at 202-408-7157 or Steve Kite at 312-245-8449), or any member of the Gardner
Carton & Douglas Health Law Department, listed below.
GARDNER CARTON & DOUGLAS
HEALTH LAW
Earl J. Barnes II (312) 245-8470 Paul Kim (202) 408-7124
ebarnes@gcd.com pkim@gcd.com
Jennifer R. Breuer (312) 245-8706 Steven B. Kite (312) 245-8449
jbreuer@gcd.com skite@gcd.com
Bernadette M. Broccolo (312) 245-8454 Demetrios Kouzoukas (202) 408-7119
bbroccolo@gcd.com dkouzoukas@gcd.com
Gregory L. Brown (312) 245-8703 Holley Thames Lutz (202) 408-7126
gbrown@gcd.com hlutz@gcd.com
L. Edward Bryant, Jr. (312) 245-8420 Ashley McKinney (312) 245-8834
ebryant@gcd.com amckinney@gcd.com
Mary Devlin Capizzi (202) 408-7101 Michael W. Peregrine (312) 245-8455
mcapizzi@gcd.com mperegrine@gcd.com
Lisa M. Chavez (312) 245-8767 William H. Roach, Jr. (312) 245-8432
lchavez@gcd.com wroach@gcd.com
Anita Cicero (202) 408-7163 Colleen Roberts (312) 245-8534
acicero@gcd.com cmroberts@gcd.com
Ralph E. DeJong (312) 245-8466 Patrick Rock (202) 408-7136
rdejong@gcd.com prock@gcd.com
Maureen Donahue (202) 408-7133 Geoffrey B. Shields (312) 245-8430
mdonahue@gcd.com gshields@gcd.com
Ramy Fayed (202) 408-7175 Carin J. Sigel (202) 408-7173
rfayed@gcd.com csigel@gcd.com
Anne Kurtz Flam (202) 408-7229 Michael J. Staab (312) 245-8781
aflam@gcd.com mstaab@gcd.com
D. Louis Glaser (312) 245-8744 T.J. Sullivan (202) 408-7157
lglaser@gcd.com tsullivan@gcd.com
L. Robert Guenther III (312) 245-8702 Douglas B. Swill (312) 245-8504
rguenther@gcd.com dswill@gcd.com
Ballard Jamieson (202) 408-7189 W. Edward Webb (312) 245-8725
bjamieson@gcd.com ewebb@gcd.com
James Jorling (202) 408-7131 Mary G. Wilson (312) 245-8512
jjorling@gcd.com mwilson@gcd.com
This client memorandum is not intended as legal advice, which may often turn on specific facts.
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