Yield Restriction (I.R.C. 148)

General Matters

Interest on “arbitrage bonds” is not eligible for tax-exemption.  Section 148(a) defines an “arbitrage bond” as any bond issued as part of an issue any portion of the proceeds of which is reasonably expected (at the time of issuance) to be used directly or indirectly (a) to acquire higher yielding investments or (b) to replace funds which were used directly or indirectly to acquire higher yielding investments.  Bonds are also “arbitrage bonds” if the issuer intentionally uses any portion of the proceeds of the issue of which the bonds are a part to acquire higher yielding investments or to replace funds which were used directly or indirectly to acquire higher yielding investments.

Yield Restriction for Project Funds

A project fund usually qualifies for unrestricted investment during a three-year temporary period for capital projects. See required expectations to be made on the issue date.  Capital projects do not include working capital items such as payment of employee salaries or other operating expenses.  An issuer that reasonably expects to meet the requirements for the three-year temporary period but actually does not make the necessary expenditures in time will generally need to make yield reduction payments under Treas. Reg. 1.148-5(c)(3)(i)(A).  An issuer would be well-advised to engage a rebate analyst to monitor spending for purposes of the yield restriction rules as well as for the spend-down requirements of any available exceptions to arbitrage rebate.

There are several temporary periods that apply instead of the three-year temporary period for capital projects. These temporary periods are:

  1. Five-year temporary period if the issue is to finance a capital project involving a substantial amount of construction expenditures on a complex construction project.  Certain certifications are required for this period.
  2. Investment proceeds, defined as income from the investment of proceeds, have a temporary period of one year from the date of receipt.
  3. Proceeds held to pay working capital expenditures, defined generally as operating expenses, have a temporary period of 13 months.

Yield Restriction for Costs of Issuance

The three-year yield restriction temporary period (described in Section 1.148-2(e)(2)) applies to amounts used to pay costs of issuance, which are considered “capital costs.”  This is in addition to amounts used to pay project costs (conventional capital costs of the project).  Costs of issuance are specifically excluded from the technical definition of restricted working capital expenditures under Section 1.148-1(b) (and see Section 1.148-6(d)(3)(ii)(A)(1) and Section 1.148-2(e)(3)), which have a separate, 13-month temporary period (i.e. that 13-month temporary period does not apply).  See Frederic L. Ballard, Jr., ABCs of Arbitrage 27; Treas. Reg. Section 1.148-2.

The Income Tax Regulations define the term “issuance costs” to mean costs to the extent incurred in connection with, and allocable to, the borrowing (Treas. Reg. Section 1.150-1). Issuance costs include: Underwriter’s spread, counsel fees, financing advisor fees, rating agency fees, trustee fees, paying agent and certifying and authentication agent fees, accounting fees, printing costs, TEFRA-related costs, cost of engineering and feasibility studies, guarantee fees, costs of carrying bonds including for instance the first periodic trustee and remarketing agent fees, “similar costs.”

The following costs are generally not considered “issuance costs”: Fees allocable to qualified guarantees, attorneys’ fees that are being incurred by the provider of a qualified guarantee in connection with the provision of the guarantee for the bonds (i.e. LOC counsel), mortgagee policy fees incurred by the conduit borrower in connection with obtaining the loan of bond proceeds.

Yield Restriction for Capitalized Interest

The three-year yield restriction temporary period also applies to capitalized interest.See Frederic L. Ballard, Jr., ABCs of Arbitrage 26; Treas. Reg. Section 1.148-6(d)(3)(ii)(A)(3).  Generally, the three-year period applies to proceeds used for a “capital project.”  A capital project includes “related” expenditures for working capital listed in the accounting regulations.  Such related expenditures include “interest on the issue for a period commencing on the issue date and ending on the date that is the later of three years from the issue date or one year after the date on which the project is placed in service.”

Yield Reduction Payments after Three-Year Period

An issuer may reasonably expect to spend proceeds in three years and then fail to spend them because of unexpected problems related to the project.  The failure to spend the proceeds in time does not invalidate the issuer’s use of the three-year temporary period, and it does not cause the bonds to become arbitrage bonds.  Instead, the proceeds are simply subject to yield restriction after the three-year period.  The regulations permit the issuer to make yield reduction payments to comply with the yield restriction requirement.  The materially higher yield to test the yield on the proceeds is the 0.125% yield spread.

Rebate Funds

The Code and Regulations do not require the use of a rebate fund. The payment of required rebate can be accomplished from any source of payment, including principal of bond proceeds, from accumulated investment income in the rebate fund or else in any other fund, from operating revenues, or from any other source. If the rebate requirement is paid from bond proceeds, of either the issue to which the fund relates or some other issue, the payment will not be treated as a use of proceeds to pay operating expenses, for purposes of the rules providing that issuers may not allocate bond proceeds to payment of operating expenses, if there are other non-bond funds that could be used to make the payment.

Mr. Ballard states that the Regulations are silent concerning the eligibility of a rebate fund for unrestricted investment. He explains that most counsel appear to regard a rebate fund as a form of reasonably required reserve fund, eligible for unrestricted investment on that basis provided that the regulatory limits on the size of a reasonably required reserve fund have not been fully used up by the “regular” debt service reserve fund. If the regulatory size limits have already been reached, counsel can often reach the same practical result by treating the rebate fund as qualifying for yield reduction payments.

Abandonment of Project

Assume on the issue date the issuer reasonably expects to spend the project fund moneys within three years.  Unexpectedly, the issuer cannot complete the project and, after five or six years, the issuer comes to bond counsel and requests advice on how to use the remaining project fund moneys.  Bond counsel should advise the issuer that moneys in the project fund may be used for another good purpose or should be used to redeem bonds in the amount of the remaining project fund moneys.  If redemption of the bonds is not possible immediately, the issuer may retain the moneys until the call limitation has ended.  There are no requirements similar to the remedial action defeasance rules with respect to excess project fund moneys for governmental bonds.

See Rev. Proc. 79-5 (Jan. 1, 1979) regarding excess bond proceeds in the context of private activity bonds.  Under the procedure, the excess bond proceeds must be used to redeem the outstanding bonds or establish an escrow for redemption.

Minor Portion

Under I.R.C. 148(e), “proceeds” may be invested in higher yielding investments as long as the amount invested does not exceed the lesser of:

  1. five percent of the proceeds of the issue (i.e., threshold is $2,000,000 in proceeds); or
  2. $100,000.

Minor Portion

The arbitrage of the minor portion is, however, subject to rebate.  Prior to enactment of I.R.C. 148(e), the regulations allowed up to 15 percent of the proceeds of the issue, net of amounts in reserve funds, to qualify as a minor portion.  The minor portion allowed by I.R.C. 148(e) is in addition to a reasonably required reserve fund.

Note that the Code states that the minor portion applies to “proceeds,” which would not include replacement proceeds.  Treas. Reg. 1.148-2(g), however, clarifies that the minor portion rule applies generally to “gross proceeds,” which does include replacement proceeds.

Calculating Yield

Issue: The IRS used to permit “yield burning” as a method for reducing the yield on investments to stay within yield restriction limits.  Investment providers benefitted from this “burning” by keeping the spread between the payment to the issuer and the sale in the market. Such burning was also possible by charging inflated administrative costs. Based on policy considerations, the IRS decided to prohibit yield burning. The following regulations were implemented as a result.

Basic Rules: The value of an investment (including a payment or receipt on the investment) on a date must be determined using one of the following valuation methods consistently for all purposes of section 148 to that investment on that date:

  1. Plain par investment: A plain par investment may be valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date.
  2. Fixed rate investment: A fixed rate investment may be valued at its present value on that date.
  3. Any investment: An investment may be valued at its fair market value on that date.

The third basic rule above is the default rule.  Fair market value is defined in section 1.148-5(d)(6) to mean “the price at which a willing buyer would purchase the investment from a willing seller in a bona fide, arm’s length transaction. Fair market value generally is determined on the date on which a contract to purchase or sell the nonpurpose investment becomes binding […]. Except as otherwise provided in [paragraph (d)(6) of such section], an investment that is not of a type traded on an established securities market, within the meaning of section 1273 [of the Code], is rebuttably presumed to be acquired or disposed of for a price that is not equal to its fair market value.”  Section 1273 of the Code is not particularly helpful in understanding how “securities market” is defined, but in many cases, it will probably be quite clear when an investment involves a securities market, and when it does not.

Example: Issuer invests bond proceeds in bank’s money market fund and makes periodic withdrawals to pay for the project. If this is a regular money market fund that depends on the amount put in and acts like a checking account, and if this type of account is available to anyone and not just users with tax-exempt bond proceeds, no special safe harbor with respect to investment valuation is needed – the fair market valuation rule applies.


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