ABCs of Reserve Funds (I.R.C. 148)

A.  Text of Law and Regulations

The general Reasonably Required Reserve and Replacement Fund (4-R Fund)  is set forth in Section 148(f)(d) and  Section 1.148-2(f)(2):

Section 148(f)(d):

(1) In general. For purposes of subsection (a) (“Arbitrage Bond Defined”), a bond shall not be treated as an arbitrage bond solely by reason of the fact that an amount of the proceeds of the issue of which such bond is a part may be invested in higher yielding investments which are part of a 4-R Fund.  The amount referred to in the preceding sentence shall not exceed 10 percent of the proceeds of such issue unless the issuer establishes to the satisfaction of the Secretary that a higher amount is necessary.

Section 1.148-2(f)(2):

(2) Exception from yield restriction for reasonably required reserve or replacement funds –

(i) In general. The investment of amounts that are part of a reasonably required reserve or replacement fund in higher yielding investments will not cause an issue to consist of arbitrage bonds. […] Amounts in a 4-R Fund in excess of the amount that is reasonably required is not part of the 4-R Fund.

(ii) Size limitation.

[A qualifying 4-R Fund] may not exceed an amount equal to the least of [a] 10 percent of the stated principal amount of the issue [note the special de minimis rule on how to calculate this], [b] the maximum annual principal and interest requirements on the issue, or [c] 125 percent of the average annual principal and interest requirements on the issue.

If an issue has more than a de minimis amount of OID or OIP (OID or OIP exceeds two percent times the stated redemption price of the bonds), the “issue price” of the issue (net of pre-issuance accrued interest) is used to measure the 10 percent limitation in lieu of its “stated principal amount.”

For a 4-R Fund that secures more than one issue (e.g. a parity reserve fund), the size limitation may be measured on an aggregate basis.

Amounts in excess of the limit set forth in the three-prong test may not be invested at a materially higher yield, otherwise yield reduction payments must be made.

B.  Discussion

Section 148(d) and section 1.148-2(f)(1) of the regulations provide two general rules for reserve funds:

  1. Don’t put more than 10% of the “sale proceeds” of an issue into a “reserve or replacement fund” and
  2. If a reserve or replacement fund is “reasonably required,” the issuer may invest sale proceeds or replacement proceeds in it without yield restriction.

The second rule is an exception to yield restriction and is not a rebate exception! There are no exceptions to rebate for reserve funds, except for the broad small issuer $5 million exception applicable to all proceeds generally.

A “reasonably required” reserve or replacement fund is one that meets the three prong test identified above under the regulations.  This test was first incorporated by Rev. Proc. 84-26.  Discussions on this test follow:

1. The 10% prong is based generally on the stated principal amount of the issue.

  • If bonds are issued at prices that differ from their stated principal amount by more than a de minimis amount, the regulations require the 10% test to be based on issue price at technically defined (1.148-1(b)).  De minimis means 2%. So, if stated principal is $10 million, issuer uses $1 million (which here assumed to satisfy the other prongs). If bonds are actually sold at a discount of 1 percent, the technical definition of issue price is $9.9 million.  The issue price is less than 2% different from that used to calculate the $1 million, so the issuer is protected and satisfies the 10% prong.
  • The de minimis rule also applies to premiums.  An original issue premium is de minimis if it does not exceed (a) 2% of principal plus (b) any portion of the original issue premium that is attributable to reasonable compensation for the bond underwriters.
  • The 10% test applies to the original amount of the issue and does not change during the life of the issue as the issuer pays off principal.

2. Maximum Annual Debt Service

  • This prong may refer to debt service on bonds remaining outstanding, but see Question 5 below.

3. 125% of the average annual debt service on the issue

  • This prong may refer to debt service on bonds remaining outstanding, but see Question 5 below.

C.  Example Language

Based on the representations of the Underwriter in the Certificate of the Underwriter attached as Exhibit __ hereto, the Reserve Fund is an essential element in the marketing of the Bonds, and as provided in such Certificate of the Underwriter, the amount of the Required Reserve does not exceed the lesser of (a) 10% of the stated principal amount of the Bonds, if the original issue discount does not exceed 2% times the stated redemption price of the Bonds, or 10% of the Issue Price, if the original issue discount does exceed 2% times the stated redemption price of the Bonds, (b) the maximum annual principal and interest requirements of the Bonds or (c) 125% of the average annual principal and interest requirements with respect to the Bonds

D.  Questions and Answers

Question 1: Assuming there are two series (considered one issue for tax purposes) and two reserve funds – one for each series – that are not parity reserve funds, must each reserve fund satisfy the 4-R Fund tests individually? Yes. Compare to Section 1.148-2(f)(2)(ii) of the Regulations relating to parity reserve funds.

Question 2: Can the borrower increase the amount deposited to a 4-R Fund with non-proceeds/equity contributions? There is a strict limit of 10% from bond “sale proceeds.” Non-proceeds in excess of this would probably be yield restricted but could qualify for yield reduction payments if the amount, when added to proceeds, does not exceed 15% of the issue price of the bonds.  See Section 1.148-5(c)(3)(i)(E) of the Regulations and page 69 of the 2007 Fundamentals of Municipal Bond Law. What happens if that percentage goes above 15%?  Section 1.148-5(c)(3)(i)(E) of the Regulations states that yield reduction payments in this case cannot be made with respect to that portion of the reserve fund over the 15% limit. (The portion within the 15% limit still qualifies for the yield reduction payments.)

See PLR 8351138 concerning a discussion of the 15% limit, the exception permitting a larger reserve fund so long as a ruling is requested and received, and overissuance discussion. (*)

Question 3: Assuming there is one 4-R Fund securing more than one issue (so-called “parity” reserve fund), must the size limitation be measured on an aggregate basis? Yes. Section 1.148-2(f)(2)(ii) of the Regulations states that “for a reserve or replacement fund that secures more than one issue (e.g., a parity reserve fund), the size limitation may be measured on an aggregate basis.  In reality, it would be best to also measure on an issue by issue basis.  In other words, test the reserve fund twice: Once against the individual issues, and once against the aggregate.

Question 4: Must the reserve fund, to be a 4-R Fund, at all times meet the three-prong test? The first prong (10%  of bond size) can never change over time. The results from the other two prongs can change. This means, at all times will these two prongs be met.

Question 5: Are the three prongs tested only at closing, or are they tested throughout the life of the bonds? Ballard in his ABCs of Arbitrage on page 40 (2007 edition) talks about how the regulations are not explicit on whether the MADS and 125% tests refer to debt service on bonds remaining outstanding or only upon issuance and goes on to talk about what happens if the reserve fund does suddenly become overfunded. Legalistically, this is correct.  But realistically you figure out what would be required for a fixed rate issue and that is the amount you are allowed. It doesn’t change as the rate changes or the bonds are paid down (same as for a fixed rate that is amortized over the life of the bonds).

Question 6: What if the reserve fund is funded solely from equity contributions? What are the yield restriction rules? The 10% limit applies only to the use of “sale proceeds” of the bonds (see 1.148-2(f)(1)). According to Mr. Ballard (page 39), an issuer can create a reserve fund using revenues instead of proceeds of the bond sale.  A reserve fund of this type would be subject to the arbitrage rules as replacement proceeds.  It can qualify for unrestricted investment under the same test of reasonableness as a reserve fund created with sale proceeds.  That test is the three prong test.

Question 7: How do the Reasonably Required Reserve or Replacement Fund tests work with General Obligation Bonds or Annually Appropriated Leases? Any fund that is intended to be a 4-R fund must be “reasonably required.” Meeting the three-prong test is a strong indication of reasonable requirement.  The Underwriter will generally also certify that the fund is reasonably necessary to sell the bonds. However, the IRS could find that, under all facts and circumstances, the fund is not reasonably required even if the three prong test is met.  In Rev. Proc. 84-26, the IRS suggests that a reserve for General Obligation Bonds might not be reasonably required (although, as Frederic Ballard indicates, “it is easy to imagine circumstances in which a reserve fund for G.O. bonds would be entirely reasonable, such as when the bonds are required to have a reserve fund to obtain insurance”).  It may also be reasonable to have a reserve for G.O. bonds where the assessed value of property underlying the general obligation pledge may fluctuate highly. The issuer may be required to provide evidence of this fluctuation and a certification as to reasonable necessity. The determination, therefore, for purposes of reserve fund tests, must be made not only on the basis of the three prong test, but also based on the facts and circumstances surrounding the reasonable necessity.

Is it reasonable to have a reserve fund for an annually appropriated lease (with or without certificates of participation)?  The annual appropriation is an appropriation from the general fund.  Unless there are factors otherwise supporting the use of a reserve fund, it does not appear that a reserve fund is reasonably needed – if the lessee appropriates, the appropriation is in full and there is no need to rely on a backstop; if the lessee fails to appropriate, the default provisions kick in.  Examples where a reserve might be reasonable include variable rate leases where the appropriation for the year may not anticipate significant increases in rates during the year.  Alternatively, a reserve fund might be reasonable if the reserve fund is required to sell the certificates.  In addition, a reserve fund can be used if it is funded with a reserve policy instead of proceeds.

Question 8: How is the 3-prong test applied to bonds with balloon maturities?  There are no special rules or changes to how the 3-prong test is applied to bonds with balloon maturities, even though it might appear that these bonds unnaturally satisfy the MADS test and perhaps even the the 125% AADS test.  Don’t worry. Be happy.

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