Casino Enterprise Management

Stimulus. Spendulus. Depending on your political persuasion the name may change, but whatever the moniker, there is a new $800 billion gorilla in the United States following the enactment of the American Recovery and Reinvestment Tax Act of 2009 (Recovery Act). The act has plenty of new incentives designed specifically for Indian country. Two specific items of note, which may impact gaming in Indian country, are the introduction of Tribal Economic Development Bonds (TED Bonds) and $2.5 billion in spending for Indian country initiatives.

As liquidity has evaporated from the credit markets, the development of several casino and resort projects have been delayed or outright shelved. Casino gaming facilities are almost always universally financed through taxable debt markets. Local governments, on the other hand, increasingly have tapped tax-exempt markets to finance new hotel and convention center projects. By virtue of the Internal Revenue Code of 1986, as amended (IRC), federally recognized Indian tribes can access tax-exempt financing markets when bond proceeds are used to finance “essential governmental functions.” The scope of activities that qualify as “essential governmental functions” have been the recent subject of intense debate.

The Agua Caliente Band of Cahuilla Indians (Agua Caliente Tribe) is one of the first tribes to aggressively use tax-exempt bonds. These early efforts have had repercussions for the tribe. The Agua Caliente Tribe disclosed in mid-2008 in federal securities filings that it is appealing an adverse determination by the IRS denying the tax-exempt status to $22.5 million of bonds the tribe issued during 2003. An understanding of the fight over the “essential governmental services” test provides a context of the significance of the introduction of TED Bonds.
 
The Agua Caliente Tribe IRS Appeal
The Agua Caliente Tribe originally issued approximately $22.5 million of tax-exempt bonds in 2003. The tribal bonds were issued to finance the renovation and expansion of the Canyon South Golf Course and related facilities located in Palm Springs, Calif. The Canyon South Golf Course is operated by the Agua Caliente Tribe. 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, FSA 20024712 (Nov. 11, 2002). 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.” The crux of the legal 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.

The Source of Tax-Exemption
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. An Indian tribe may, however, be treated as a state for purposes of IRC § 103 by virtue of IRC § 7871(a)(4). 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).”

There are two circumstances when an Indian tribe may issue tax-exempt bonds under IRC § 7871. First, relevant to the Agua Caliente Tribe bonds, 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.”  “Essential governmental function” is further defined in IRC § 7871(e) in the negative by informing us that an essential governmental function does “not include any function which is not customarily performed by state or local governments with general taxing powers.” As is typical with tax laws, the statutory language is far from crystal clear and leaves many unanswered questions. Second, although not relevant to the Agua Caliente Tribe’s bonds, a tribe may issue bonds to finance certain manufacturing facilities.1

Under federal tax law, 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.”2 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.

The Dispute Over the Meaning of “Essential Government Function”
At the outset, as mentioned above, IRC § 7871(e) limits the definition of “essential government function” to exclude activities “not customarily performed” by states. As the role of government has dramatically evolved during the last half-century, and even more drastically in response to the current financial crisis, the functions that are capable of being construed to be “customarily performed” by government has correspondingly expanded. Thus, the inquiry is no easy task.

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.

Applying the two-step analysis, the IRS noted in FSA 20024712 that “it is probable that a court, faced with this fairly common activity [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.” The lengthy discussion of the litigation hazards in FSA 20024712 and other IRS authorities provide some indication that the ultimate result in litigation may very well by that the operation of a golf course, including even a high-end golf course such as the Canyon South Golf Course, is an “essential governmental function” under IRC § 7871. The legal arguments to reach this conclusion are twofold:

1.  Examine the Legislative History and Similar Activities of States and Local Governments.
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.” Viewing the congressional modification of the IRC § 7871 regulations as narrowing the restrictions of the IRC on tribes’ issuing tax-exempt bonds leads to an examination of recreational activities state and local governments own and operate. FSA 20024712 noted that there are a large number of golf courses which are owned 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. 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.

2. Examine Other Areas of Tax Law for Guidance. Tax attorneys are often left with the limited option of examining similar provisions of the tax law to discern the meaning of undefined statutory terms. Applying this form of analysis, Private Letter Rulings issued under analogous provisions of the federal tax law offer support for the proposition that the operation of golf courses, among other recreational facilities, can qualify as an essential governmental function.

For example, activities recognized as “exempt purposes” under IRC § 501(c)(3) includes activities of organizations that lessen the burdens of government. The standard for lessening the burdens of government adopts a similar analysis, as the analysis to determine if an activity is an essential government function. That is, under the lessening the burdens of government standard, an activity must be one that 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 that lessened the burdens of government. The IRS’ “lessening the burdens” analysis provides some support to argue that the scope of the activities that are a government’s “burden” for IRC § 501(c)(3) purposes are substantially similar to essential governmental functions. That is, if an activity can be one that a government considers its burden, then the activity should similarly be viewed as an essential governmental function or, minimally, offer persuasive authority of the types of activities that could qualify as essential governmental functions.

The IRS’ Counter-argument
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 bonds. 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. 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.3 The Chief Counsel itself noted in FSA 20024712 that the facts of the Aqua Caliente Tribe’s bond issues represented an “extreme case” that may support advancing the argument that the bonds are not issued for a customary essential governmental function.

Introduction of Tribal Economic Development Bonds
The waning days of the 110th Congress saw a push to create new economic development tools for Indian tribal communities. Wayne Shammel, general counsel to the Cow Creek Band of Umpqua Tribe of Indians, offered testimony that identified the barriers Indian tribes experience to access tax-exempt financing markets under then-existing federal tax law.4 Shammel offered several recommendations to improve tribal governments’ access to tax-exempt financing, which included repealing the “essential governmental functions” test, equalizing federal securities exemptions for Indian tribes offering bonds, and increasing tribes’ ability to issue private activity bonds.5   

The 111th Congress, on its way to the forum to pass an economic stimulus package, apparently heeded Shammel’s advice. The Recovery Act creates a new class of tax-exempt bonds: “tribal economic development bonds.” TED Bonds may be issued to finance on a tax-exempt basis any project that a state or local government may finance on a tax-exempt basis. Significantly, the Recovery Act eliminates the “essential governmental functions” test.

Congress nevertheless did impose limitations on the use of TED Bonds: (1) the bonds cannot be used to finance a building where Class II or Class III gaming is conducted; (2) there is a $2 billion national limit, and (3) bonds may only be issued during 2009 and 2010. The $2 billion national limitation will be allocated among tribes by the Secretary of the Treasury, in consultation with the Secretary of the Interior. Thus, the Recovery Act does not specify precisely how the national limitation will be allocated among tribes. There is some reasonable suspicion that national limitation will be allocated on a first come, first serve basis.

Conclusion
The Recovery Act greatly enhances the ability of Indian tribes to tap into the tax-exempt financing markets. Offering greater access should, 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 that complement casinos. Nonetheless, there are two answers that the Recovery Act cannot provide. First, a market for TED Bonds. Thus far, by an informal survey of investment bankers, the markets are at best lukewarm to purchasing TED Bonds. Second, resolving the Agua Caliente Tribe’s appeal. This second question may very well be left for the courts to decide. Thus, substantial challenges to enhancing tribal economic development—including Indian gaming—still remain.

Footnotes
1 More specifically, the second circumstance involves the issuance of bonds known as “private activity bonds” that meet specific requirements to finance certain manufacturing projects.

2 Joint Committee on Taxation, Overview of Federal Tax Provisions Relating to Native American Tribes  and Their Members (JCX-61-08) (July 18, 2008).

3 See, i.e.., "Calif. Tribe Appeals IRS Golf Ruling," The Bond Buyer (July 17, 2008).

4 The Cow Creek Band of Umpqua Tribe is a long-time client and friend of Dickinson Wright attorney Dennis Whittlesey. Whittlesey may be reached via e-mail at dwhittlesey@dickinsonwright.com.

5 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.

Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville,  Washington, D.C., Toronto and an affiliated office in Macau. Peter received his LL.M in tax law from New York University. Peter may be reached via e-mail at pkulick@dickinsonwright.com.