Proceeds of Bonds Used for Reimbursement

May 27, 2011

Background:

Treasury Regulation §1.150-2, issued pursuant to Section 150 of the Internal Revenue Code of 1986, as amended, prescribes certain requirements by which proceeds of tax-exempt bonds, notes, certificates or other obligations included in the meaning of “bonds” under Section 150 of the Code used to reimburse advances made for Capital Expenditures paid before the issuance of such Obligations may be deemed “spent” for purposes of Sections 103 and 141 to 150 of the Code and therefore, not further subject to any other requirements or restrictions under those sections of the Code.

Such Reimbursement Regulations require that the Issuer make a Declaration of Official Intent to reimburse any Capital Expenditure paid prior to the issuance of the Obligations intended to fund such Capital Expenditure and require that such Declaration of Official Intent be made no later than 60 days after payment of the Capital Expenditure and further require that any Reimbursement Allocation of the proceeds of such Obligations to reimburse such Capital Expenditures occur no later than 18 months after the later of the date the Capital Expenditure was paid or the date the property acquired with the Capital Expenditure was placed in service, except that any such Reimbursement Allocation must be made no later than three years after such Capital Expenditure was paid.

Discussion of certain frequent related matters:

What is the significance of the reimbursement rules?

The general federal tax law is that no reimbursements from bond proceeds are permitted for capital expenditures made prior to the issuance of the bonds unless certain procedures have been followed.  The point of the reimbursement rules, therefore, is to set forth the circumstances in which use of proceeds of bonds constitutes a valid “expenditure” of bond proceeds, reducing the amount of unspent bond proceeds, or as summarized by Frederic Ballard in his 2011 edition of the ABCs of Arbitrage, a “reimbursement that complies with the regulations has the effect of moving the reimbursement amount outside the arbitrage rules.”

A reimbursement allocation (i.e., use of bond proceeds to pay expenditures made before the issue date) is treated as a valid “expenditure” of bond proceeds for the governmental purpose of the original expenditure on the date of the reimbursement allocation only if the requirements listed in Treas. Reg. 1.150-2(d) are met:

  1. Issuer must have adopted an official intent for the original expenditure; and
  2. The reimbursement allocation must be made not later than 18 months after the later of (a) the date the original expenditure was paid or (b) the date the project is placed in service or abandoned.  Note: In any case, the reimbursement allocation must be made not more than 3 years after the original expenditure is paid.
The regulations permitting reimbursement with bond proceeds apply to bonds issued to finance capital expenditures, not to bonds issued to finance working capital.  A reimbursement allocation that is made within 30 days after the issuance of the bonds is treated as a reimbursement allocation made on the issue date – meaning those proceeds are treated as spent on the closing date, not on such later date, and are therefore “exempt from yield restriction and rebate.”  Reimbursement allocations made after 30 days after the issue date are treated as bond proceeds spent on the date of such reimbursement allocation date.
A project facility (such as a hospital building) that consists of several components (separate floors, for example), each of which may have a separate placed in service date, should be tested with respect to each such placed in service date and not simply by using the latest placed in service date.

What is a reasonable deviation from the project description under Treas. Reg. 1.150-2(e)(2)(iii):

[To come]

Can a reimbursement resolution be used to cover capital expenditures relating to more than one series of bonds:

Yes, so long as the project is defined properly to encompass the project being financed with the multiple series of bonds.  Be careful to examine the capital expenditures to be reimbursed. Those expenditures must fit within the “reimbursement period” definition described in (d)(2).

May issuer make a reimbursement allocation after the closing?

Yes. See the discussion under the first question.

Once financed, not reimbursed:

Section 1.150-2(g)(1) provides that a reimbursement allocation is not treated as an expenditure of proceeds if the allocation is to pay principal or interest on an obligation or to reimburse an original expenditure paid by another obligation.  Such allocation is instead analyzed as a refunding.

In PLR 9417027, the Issuer issued a bond anticipation note.  Before the maturity of the note, the finance director died.  The Issuer used other moneys to redeem the note upon maturity with general fund moneys and subsequently issued bonds to reimburse the general fund and finance additional project costs.  While the bonds technically did not constitute refunding bonds because the proceeds were not used for debt service (and should have been tested as new money bonds), the IRS permitted refunding treatment considering the facts and circumstances.

Is a capital expenditure on the closing date, reimbursed on the closing date a “Reimbursement”?

Assume on Day 1, the issuer wires its own money to a seller of property to purchase a new facility.  Later in the day on Day 1, the issuer issues its new money bonds for the purpose of financing the purchase of such facility and receives the purchase price for the bonds.  Is the initial wire to the seller an “original expenditures” with respect to which the bonds are reimbursement bonds?  Most bond counsel would probably find that the bond is not a reimbursement bond – for all intents and purposes, the bond proceeds were used to finance the purchase. Some bond counsel might even consider payment one or two days in advance a new money and not a reimbursement situation.

What is the De Minimis Exception?

The official intent requirement and the reimbursement period requirement do not apply to costs of issuance of any bond or to an amount not to exceed the lesser of $100,000 or 5% of the proceeds of an issue.

(Fundamental of Municipal Bond Law – 2007 and Treas. Reg. 1.150-2(f))

De minimis dog

What this means is that the special exception for preliminary expenditures also applies to non-preliminary expenditures so long as the total of that non-preliminary expenditure reimbursement is the lesser of those two numbers, or if the reimbursement is used to pay costs of issuance for any bond.  For instance, if the proceeds of an issue amount to $6,000,000, the de minimis limitation of $100,000 applies, and the borrower may request a reimbursement up to that amount for expenditures that would not otherwise satisfy the official intent requirement (no later than 60 days after the date of payment) or the reimbursement period requirement (allocation no later than 18 months after etc.), or both requirements.  But note that all other requirements of the reimbursement rules must be met. It is simply the case that these two requirements (in (d)(1) and (d)(2) of the regulations) do not apply. Notiz 20111227.

Do the same reimbursement rules apply to qualified tax credit bonds?

No. There are separate reimbursement rules and requirements for these types of bonds. See, e.g., the rules relating to New Clean Renewable Energy Bonds.

Are there special rules for disaster area bonds?

Yes.  See Notice 2010-10 regarding special reimbursement rules for disaster area bonds.

Can Prior Working Capital Expenditures be Reimbursed under the normal De Minimis Related Working Capital Expenditure Rule?

Assume a previously paid expenditure is not capitalized into the cost of the project but is instead working capital directly related to capital expenditures financed by the issue. If the expenditure is incurred post-issuance and then paid from bond proceeds, the expenditure could fall within the exception in Treas. Reg. 1.148-6(d)(3)(ii)(A)(5) if the total of such expenditures does not exceed 5 percent of the sale proceeds of the issue.  However, assume such expenditure was paid prior to the bond issuance.  May there be a reimbursement to the issuer for the expenditure?  No, not under the 148 regulations.  The reimbursement regulations (Treas. Reg. 1.150-2(d)(3)) state that the expenditure must be either a capital expenditure, a cost of issuance for a bond, an expenditure for certain extraordinary working capital items, a grant, a qualified student loan, a qualified mortgage loan or a qualified veterans’ mortgage loan – but not for a de minimis working capital expenditure.  Solution: Either (1) get an accountant to state that the cost is capitalized into the cost of the project – in other words, get the accountant to determine that it actually is a capital expenditure, or (2) there is no second solution.

Timing example, and what happens when a reimbursement resolution becomes stale: 

The special rules relating to the reimbursement period requirement have the following significance: Assume a capital expenditure was paid on March 1, 2009 for a construction project that was not placed in service until March 1, 2011, and the issuer (or conduit borrower, in the case of qualified 501(c)(3) bonds) adopted a reimbursement resolution (the official intent) on April 30, 2009, the issuer or borrower may use bond proceeds to be reimbursed for such expenditure as late as March 1, 2012 (provided the allocation of proceeds to the March 1, 2009 expenditure is made no later than March 31, 2012).  Reimbursement allocations during this period may be made from one or more bond issues.  However, once the reimbursement period has expired with respect to a prior expenditure, the issuer or conduit borrower, as applicable, may no longer be reimbursed for such capital expenditure, unless (1) a subsequent reimbursement resolution (official intent) was adopted within 60 days of payment of the original expenditure, (2) the de minimis exception applies to the expenditure or (3) the preliminary expenditure exception applies to the expenditure.

Does the reimbursement rule apply for reimbursements from taxable bond proceeds:

The reimbursement rules apply in connection with reimbursements paid with proceeds of a taxable bond. See, e.g., PLR 200116004.

Example of the One-Year Step Transaction Anti-Abuse Rule:

An example of a transaction possibly violating the one-year step transaction rule is (1) the issuance of new money bonds, (2) reimbursement from bond proceeds, and (3) within one year, funding a cash defeasance to defease or discharge prior bonds.  Could this situation be recharacterized as the use of bond proceeds to fund the escrow (and the reimbursement allocation would therefore not constitute an expenditure of proceeds)?  The bonds would therefore be refunding bonds.  See Treas. Reg. 1.150-2(h)(2).


$150 Million Volume Limitation for Qualified 501(c)(3) Bonds (Nonhospital)

May 23, 2011

Rules Relating to the $150 Million Volume Limitation:

The general rule is that, while “qualified 501(c)(3) bonds” are not subject to state volume cap rules of Section 146 of the Internal Revenue Code of 1986, as amended (the “Code”), an organization described under Section 501(c)(3) of the Code may not be the “beneficiary” of more than $150 million of outstanding bonds that not “qualified hospital bonds.”  This is called the “$150 million limitation.”

Whether an organization is a “beneficiary” within the meaning of the general rule is determined using the test-period beneficiary concept borrowed from the qualified small issue bond provisions.  Under these rules, an organization generally is a test-period beneficiary if it is an owner or principal user of bond-financed facilities during a three-year period beginning on the later of the date such facilities are placed-in-service or the date the bonds are issued.  Organizations under common management and control are treated as one organization and are subject to only the one $150 million limit. See PLR 9326027.  There are special approaches that attempt to describe when 501(c)(3) organizations are related to one another.

“Qualified hospital bonds” are bonds at least 95% of the net proceeds of which are used with respect to a “hospital.”  A “hospital” generally consists of an institution that is accredited by the Joint Commission (the JCAH) or another program of a qualified governmental unit in which such institution is located, is primarily used to provide to inpatients certain medical services, has a requirement that every patient be under the care and supervision of a physician and provides 24-hour nursing services.  A “hospital” expressly does not include rest or nursing homes, daycare centers, medical school facilities, research laboratories or ambulatory care facilities.  See also House Committee report section d regarding Section 1301 of the 1986 Act (p. 1469 in CCH Reports) (See HR Rep No 426, 99th Cong, 1st Session, December 7, 1985, pages 540 and 541 AND HR Rep No 841, 99th Cong., 2d Session., September 18, 1986, pages 725 and 726.)

The 1997 Act (P.L. 105-34) repealed the $150 million limitation for bonds that are issued after August  5, 1997, if at least 95% of the net proceeds of such bonds are used to finance capital expenditures.  The repeal does not apply to refunding bonds, to new money bonds issued to finance capital expenditures incurred on or before August 5, 1997 or to new money bonds more than 5% of the net proceeds of which are used to finance working capital expenditures.

See also Chapter XII of Fundamentals of Municipal Bond Law 2007 from which portions of the above summaries were taken.


Net Interest Cost, True Interest Cost, All-In True Interest Cost

May 19, 2011

Colorado Statutory Rules:

For purposes of Article 1, Title 32 of the C.R.S.:

“Net effective interest rate” = “Net interest cost” of the bonds / SUM[(principal amount of bonds maturing on maturity date 1 * number of years from their date to that maturity date) + (principal amount of bonds maturing on maturity date 2 * number of years from their date to that maturity date) + (etc.)]

Net effective interest rate must be calculated without regard to any option of redemption price to the designated maturity dates of the bonds.

“Net interest cost” = Total amount of interest to accrue on the bonds from their date to their respective maturities, less the amount of any premium or plus the amount of any discount.  Net interest cost must be calculated without regard to any option of redemption prior to the designated maturity dates of the securities.  In other words, net interest cost is the total interest less the amount of premium or plus the amount of discount.

For purposes of Article 90, Title 24 of the C.R.S.:

“Net effective interest rate” means the net interest cost of securities divided by the sum of the products derived by multiplying the principal amount of the securities maturing on each maturity date by the number of years from their date to their respective maturities.  In all cases, the net effective interest rate shall be computed without regard to any option of redemption prior to the designated maturity dates of the securities.

The “net interest cost” concept is applicable in the following state law circumstances:

  • Refundings under the Public Securities Refunding Act (see 11-56-104, -105, -106, -107, C.R.S.)
  • Colorado Recovery and Reinvestment Finance Act of 2009 (see 11-59.7-105, C.R.S.)
  • Refunding bonds for schools (see 22-43-103, -105, C.R.S.)
  • Refunding bonds for postsecondary education/junior colleges (see 23-71-603, -605, C.R.S.)
  • Refunding bonds for counties (see 30-35-703, C.R.S.)
  • Refunding bonds for municipalities (see 31-21-203, C.R.S.)

Other Related Matters:

The interest payment to investors and the underwriter’s profit together comprise Net Interest Costs, which is the usual measure of bond financing costs. For example, if an underwriter purchases a bond issue at an interest rte of 9.4 percent, and resells (“reoffers”) it to the final investor for 9.1 percent, the NIC is composed of an interest cost of 9.1 percent and an underwriter’s profit or spread of 0.3 percent.

“True interest cost” (TIC) = Par value + accrued interest + premium – discount – underwriter’s discount (but not costs of issuance and not other amounts) = target value for present value calculation.  Figure the yield at which the present values of the payments made on the bonds equal this target value.

“All-in true interest cost” (All-In TIC) = Par value + accrued  interest + premium – discount – underwriter’s discount – costs of issuance – other amounts = target value for present value calculations.

“Arbitrage yield” (Arb Yield) = Par value + accrued interest + premium – discount = target value for present value calculations.  Because none of the expenses are deducted for purposes of coming up with the arbitrage yield, the arbitrage yield necessarily is lower than the TIC or All-In TIC.


Volume Cap Matters

May 14, 2011

Annual Volume Cap Information

Volume cap for 2017: https://www.housingonline.com/2017/03/01/irs-releases-population-estimates-2017-affecting-lihtc-ceiling-private-activity-bond-caps/

Population estimates: https://www.irs.gov/irb/2017-09_IRB/ar08.html

How much volume cap should be requested?

Under Section 146, which applies to non-501(c)(3) private activity bonds, the amount of volume cap allocated must equal the “aggregate face amount” of the bonds.  The Treasury Department and the IRS have taken the position that “aggregate face amount” in this context means “issue price.”  This means aggregate face amount is to include any net premium.  Therefore, bond counsel firms typically recommend that volume cap be requested in excess of the pure face amount of the bonds, just in case any premium is generated.

See PLR 9431007 in which the Internal Revenue Service explains that “aggregate face amount” in Section 146(a) and 146(f), given the history of the section, means “issue price,” at least with respect to bonds issued with an original issue discount.

Is a volume cap allocation needed for Refunding Bonds?

Assume that multifamily housing bonds (the “Refunded Bonds”) were issued with appropriate volume cap allocation from a local jurisdiction or from the statewide balance.   These Refunded Bonds are now proposed to be refunded with a series of refunding bonds (the “Refunding Bonds”).  In what circumstances will additional volume cap need to be requested under the Internal Revenue Code of 1986, as amended (the “Code”) and the regulations thereunder (the “Regulations”)?

Subsection (i) of Section 146 of the Code describes the treatment of refunding issues for purposes of volume cap allocation.  Subsection (i) states that a bond issued to refund another bond is not considered a “private activity bond,” for purposes of the volume cap requirement, to the extent that the amount of such bond does not exceed the outstanding amount of the refunded bond.  There are special rules for student loan bonds and qualified mortgage bonds, and Subsection (i) does not apply to any bond issued to advance refund another bond.

See PLR 201447023 (August 1, 2014):  Bonds issued to refinance 144(b)(1)(B) student loans satisfy the nexus requirement and can be used to refinance capitalized and accrued interest on the original loans.

Carryforward of Volume Cap

Volume cap for a calendar year may be carried forward under the provisions of I.R.C. 146(f).  Such subsection provides that an issuing authority may elect to treat all or any portion of excess volume cap as a carryfoward for 1 or more carryforward purposes.  In the election, the authority must (1) identify the purpose for which the carryfoward is elected, and (2) specify the portion of the excess which is to be a carryforward for each such purpose.

Private activity bonds issued in future years with respect to a carryforward purpose are not taken into account under I.R.C. 146(a) to the extent the amount of such bonds does not exceed the amount of the carryfoward elected for such purpose.  Carryforwards elected with respect to any purpose must be used in the order of the calendar years in which they arose.

An election to carryfoward (and any identification or specification contained therein), once made, is irrevocable.

Carryfowards are permitted only for the following purposes:

  • For the purpose of issuing exempt facility bonds described in one of the paragraphs of I.R.C. 142(a) (e.g., airports, docks and wharves, etc.)
  • For the purpose of issuing qualified mortgage bonds or mortgage credit certificates
  • For the purpose of issuing qualified student loan bonds
  • For the purpose of issuing qualified redevelopment bonds

Carryforward of volume cap may not be done for small issue bonds.

Carryforwards are good for three calendar years after the original calendar year of allocation and are used in the order in which they are elected.  A carryover does not need to be renewed throughout the three-year period.  The original carryover applies for all three years.  In other words, the issuer does not need to carry over the original excess from one year to the next with another IRS Form 8328 filing.

On Form 8328, Carryforward Election of Unused Private Activity Bond Volume Cap, Part II (lines 1 through 6) relates to volume cap of the current year, and is not used to identify allocations of carryforward volume cap.  The Form 8328 must be filed by the earlier of February 15 of the year following the year in which the excess has arisen or the date on which bonds are issued pursuant to the carryforward allocation.

PLR 201615008 (Jan. 13, 2016): A public authority was granted a 45-day extension of time to file Form 8328, Carryforward Election of Unused Private Activity Bond Volume Cap, to make a carryforward election under Code Sec. 146(f) with respect to a specified amount of unused private activity bond volume cap. The entity acted reasonably and in good faith, and granting the relief did not prejudice the government’s interests.

Rev. Proc. 2005-30 provides an automatic six-month extension of the filing date if the issuing authority files Form 8328 within six months of the original due date and meets the following additional conditions: (1) the issuing authority must print or type on the top of the form “FILED PURSUANT TO REV. PROC. 2005-30,” (2) the Internal Revenue Service has not provided the issuing authority with written notice that it failed to make the carryforward election timely, (3) the late filing does not represent a reversal of an earlier decision not to file a carryforward election by the due date, (4) the late filing is not in reaction to changed circumstances after the filing date, and (5) all other requirements for the filing are met. Rev. Proc. 2005-30 is available for download from the Internet at: http://www.irs.gov/irb/2005-22_IRB/ar09.html.

PLR 201528005: Extension to file carryforward election.

PLR 200208014 (Nov. 20, 2001):  In this PLR, the Internal Revenue Service determines that the Authority (which is a successor issuer to the Administration) will succeed to any carryforward election properly made by the Administration and will be able to use that carryfoward to the same extent that the Administration could have used that carryforward had it remained in existence.

Other Matters

The Bond Buyer, “Draw-Down Bond Issuers are Satisfied With New IRS Guidance on PAB Cap,” August 4, 2011:  Guidance by the IRS in November 2010 indicated that draws of draw-down bond proceeds in different years would require additional volume cap allocations.  New guidance provided on August 3, 2011, however, reverses course. In that guidance, the IRS states that an issuer can consider the bonds “issued at the first draw of bond proceeds for purposes of obtaining an allocation of PAB Cap.  The issuer can carry the cap forward for three years for the bonds, even though some of the bond proceeds may not be drawn down until the second or third year after issuance.”

See Notice 2010-81 and Notice 2011-63 (especially the 2011 notice) concerning rules on how to allocate volume cap to draw-down bonds with draws in differing years.

See FSA 001678 (Jan. 31, 2004) regarding delegation of volume cap determination from the legislature to the governor.


Exceptions to Arbitrage Rebate

May 6, 2011

Rebate!

General Rebate Rule:

Any profit from investing bond proceeds at a yield above the bond yield belongs to the federal government and must be rebated (this is like a 100% tax on profits).

Summary of Rebate Exceptions:

  1. Any issue the proceeds of which are spent within six months;
  2. Any issue for a capital project, including an issue of qualified mortgage bonds, provided the proceeds are spent within 18 months on a semiannual spending schedule;
  3. Any issue of construction financing with governmental bonds, 501(c)(3) bonds, and a few other types of PABs, provided the proceeds are spent within two years on a semiannual spending schedule;
  4. Issuers that qualify as “small issuers” defined as issuers whose total tax-exempt financing in a calendar year is not expected to exceed $5 million (IDBs and other PABs cannot qualify for this exception and do not count toward the $5 million limit);
  5. Proceeds invested in tax-exempt obligations;
  6. Proceeds invested in SLGS;
  7. Bona fide debt service funds, subject to a limit of $100,000 on annual earnings in the case of private activity bonds or governmental bonds that do not have a fixed rate of interest and a maturity of at least five years.
The 1993 regulations contain several general rules that apply to the 6-month, 18-month and 2-year rebate exceptions:
  1. Each exception is independent (meaning, an issue may qualify under more than one exception);
  2. The exceptions are not mandatory (meaning, an issuer may pay rebate even if it actually complies with an exception);
  3. In applying the exceptions to refunded issues, the transferred proceeds rule is ignored (meaning, the unspent proceeds are still analyzed as proceeds of the refunded issue);
  4. A portion of a multipurpose issue properly allocable to a refunding purpose is treated as a separate issue (must make multipurpose allocation);
  5. Any failure to satisfy the final spending requirement of the 18-month or 2-year exception is disregarded if the issuer exercises due diligence to complete the project and the unspent amount does not exceed the lesser of 3% of the issue price or $250,000; and
  6. For pooled financing, an issuer can elect to apply spending exceptions separately to each conduit loan.

Small Issuer Exception:

Frederic L. Ballard, Jr. has a good description of the small issuer exception starting on page 47 of the “ABCs of Arbitrage,” 2011 edition.

The small issuer exception from rebate applies generally to an issue of governmental bonds by a municipality that does not expect to issue more than $5 million of governmental bonds in that calendar year.  The exception applies automatically to issues that comply with its requirements. No election is necessary.

The bonds must be governmental bonds. Private activity bonds (including qualified 501(c)(3) bonds) do not qualify for the exception.

For purposes of determining whether an issuer expects that it will not issue more than $5 million aggregate “amount” of governmental bonds, one looks to the face amount of an issue, not the issue price, so long as the issue does not have more than a de minimis amount of original issue discount or premium.   See Treas. Reg. 1.148-8(c)(1).  De minimis is defined as 2% and this test is applied in the same way the reserve fund test is applied for purposes of the 10% prong.  See Treas. Reg. 1.148-1(b).

Under Section 148(f)(4)(D)(v) of the Code, there are some exceptions and special rules in applying the small issuer exception to refunding issues.  For instance:

  1. To determine whether the $5 million limit applies, do not count current refunding bonds – to the extent the amount of current refunding bonds does not exceed the outstanding amount of the refunded bonds.  This presumably means that an amount of the current refunding bonds that exceeds the outstanding amount of the refunded bonds must be counted.  See Section 148(f)(4)(D)(iii) of the Code.
  2. Refunding bonds, as a basic rule, DO NOT (but see below, too) qualify for the small issuer exception UNLESS:
    • The aggregate face amount of the refunding portion of the issue does not exceed $5,000,000;
    • Each refunded bond was issued as part of an issue that satisfied the small issuer exception;
    • The average maturity date of the refunding bonds issued as part of such issue is not later than the average maturity date of the bonds to be refunded; and
    • No refunding bond has a maturity date which is later than the date which is 30 years after the date the original bond was issued.

The small issuer exception is an “expectation” test.  Therefore, if the issuer issues $4,000,000 in bonds that are subject to the exception, but later in the year issues another $5,000,000 for an unexpected need (for example, to fund a litigation judgment), the first issue will not lose rebate exception treatment.

Some bond counsel have determined, after examining the legislative history of the 1988 technical amendments relating to Section 265(b)(3) and to the small issuer exception itself (“refunding bonds are themselves eligible for this exception from rebate only if”), that refunding bonds that do not meet the test under 148(f)(4)(D)(v) of the Code can still qualify for the small issuer exception as long as the bonds satisfy the basic test.

Note for refunding bonds that the average maturity date of the refunding bonds may not be later than the average maturity date of the refunded bonds.  In a multi-purpose issue setting (e.g., an issue consisting of a new money portion and a refunding portion), the issue must be allocated using the allocation rules in Treas. Reg. 1.148-9(h), which requires, for instance, a pro rata allocation.  It may be difficult to achieve this test when the total issue has a longer maturity date and the new money portion is purportedly added to the back of the maturity schedule.  The pro rata allocation requirement (and probably the other alternatives) will cause the refunding bond WAM to extend beyond the average maturity of the refunded bonds.  In this case, it would be better to forego the small issuer argument and simply rely on other exceptions to rebate.

Question:  How does the small issuer rebate exception apply to improvement district?  For example, assume the district has the power to condemn property and to levy special assessments as an on-behalf-of issuer or a subordinate entity to the municipality or the county that created it – does it need to be aggregated with such entity or can it stand alone for purposes of the $5 million issue size limitation?  Answer:  Remember, an issuer and all entities other than political subdivisions that issue bonds on behalf of that issuer are treated as one entity for purposes of the small issuer exception to rebate under Treas. Reg. § 1.148-8(c)(2).  The question, therefore, is whether the improvement district is a separate political subdivision.  Assessments are not taxes for this purposes.  So, the answer turns on whether the district has unfettered right of eminent domain or whether the power to condemn is subject to the approval of another governmental unit such as the county.  If the power is contingent on approval, the district will not be considered a separate political subdivision and will be aggregated with the county.

Note: The bona fide debt service reserve fund rule is an exception from yield restriction and not a rebate exception.  There is no rebate exception for reserve funds, except for this small issuer exception from rebate.

Bona Fide Debt Service Fund Exception:

The regulations provide generally that a bona fide debt service fund is a fund “used primarily to achieve a proper matching of revenues with principal and interest within each bond year.” These funds become subject to the arbitrage rules under the replacement proceeds definition but have a generally preferred status for arbitrage purposes. Investments in a bona fide debt service fund will be exempt from yield restriction for a 13-month temporary period, and in most cases they will also be exempt from rebate under a specific exemption for debt service funds under Section 148(f)(4) of the Code. […] A bona fide debt service fund is exempt from rebate for any bond year in which the fund has gross earnings of less than $100,000.  Section 148(f)(4)(A) creates this exemption by providing that earnings on the fund do not count in determining an issuer’s rebate amount. [There are numerous special rules relating to the rebate exception.]

(See Frederic L. Ballard, Jr., ABCs of Arbitrage 2007, page 64)

Also, fixed rate governmental bonds with an average maturity of at least 5 years meet the test under section 148(f)(4)(A).  Otherwise, must met one of the following tests: (1) earnings do not exceed $100K per year; or (2) average annual debt service is not more than $2.5 million.

Spending Exceptions:

Exemption from arbitrage rebate if the issuer spends proceeds (includes investment proceeds) within 6, 18 or 24 month schedules (Project Fund, etc., but not Reserve Fund).

  1. 6-Month Exception: [See next heading]
  2. 18-Month Exception:
  3. 2-Year Exception:  A “construction issue” of governmental bonds, 501(c)(3) bonds or private activity bonds for governmentally owned facilities is exempt from rebate under the 2-year rebate exception if the issuer spends all of the “available construction proceeds” within two years in accordance with a semiannual expenditure schedule.  There are a few elections that may be relevant and that should be made at or prior to issuance.
  4. De Minimis Rule:  Under Treas. Reg. 1.148-7(b)(4), a failure to satisfy the final spending requirement of the 18-month exception or the 2-year exception is disregarded if the issuer exercises due diligence to complete the project financed and the amount of the failure does not exceed the lesser of 3% of the issue price of the issue or $250,000.

6-Month Spending Exception:

It is expected that: (a) substantially all of the gross proceeds of the bonds will be expended on the governmental purpose of the bonds within six months of the issue date date; and (b) the intended use of the sale proceeds will not cause the bonds to be characterized as “private activity bonds” within the meaning of Section 141 of the Code and Section 1.150-1(b) of the Regulations. The obligation to pay rebatable arbitrage to the United States of America will be treeated as satisfied with respect to the gross proceeds of the bonds if such gross proceeds are spent on the goverbmental purpose of the issuer within six months after the issue date of the bonds.

The 6-month spending exception to rebate is the only spending exception for refunding issues.

The exception does not apply to or affect proceeds on deposit in a debt service reserve fund.  Those proceeds do not have to be spent, but they are subject to rebate.  Thus, where a reserve fund is included in the issue, this 6-month exception is only a partial exception that does not apply to such reserve fund.

Special rules apply for tax and revenue anticipation notes or bonds (TRANs) and concern “cumulative cash flow deficit” determinations.

2-Year Spending Exception:

The 2-year spending exception is available only for (1) governmental bonds, (2) qualified 501(c)(3) bonds and (3) private activity bonds that finance property that is owned by a governmental unit or a 501(c)(3) organization.  See 26 U.S.C. 148(f)(4)(C).  See also Treas. Reg. 1.148-7(3).

The 2-year spending exception only applies to bonds at least 75% of the available construction proceeds (ACP) of which is to be used for construction expenditures (which includes rehabilitation expenditures).

Arbitrage rebate is nevertheless applicable to non-ACP amounts (such as the reasonably required reserve or replacement fund after the 2-year period).  Note: Earnings on a 4-R fund are included in ACP for the period from the issue date until the earlier of the date construction is substantially completed or 2 years from the issue date.  An issuer may, however, irrevocably elect on or before the issue date to exclude 4-R fund earnings from ACP, in which case such earnings are instead subject to rebate from the issuance date as part of the 4-R fund.

“Construction Expenditures” is defined in Treas. Reg. 1.148-7(g) and means (1) capital expenditures that may be capitalized as part of the basis of real property, excluding expenditures for land or existing real property that is not land, and (2) constructed personal property which is tangible personal property or specially developed computer software if certain requirements are satisfied.

“Real property” is not defined under local law. Instead, the regulations define real property as: (1) land and improvements to land such as buildings or other inherently permanent structures, including items that are structural components of such buildings or structures; and (2) interest in real property.

No particular election is necessary on or before the issue date in order to apply the 2-year spending exception.  There are, however, special application elections that can be made, and if made, must be made on or before the issue date.  As a practical matter, the tax documents at closing should identify the expectation (subject to the actual facts and circumstances election) that the issue qualifies as a construction issue and provide the then-current ACP calculation.  Possible issue date elections include:

  1. Election under Treas. Reg. 1.148-7(k) to pay the 1.5 percent penalty in lieu of the obligation to pay the rebate amount on ACP upon failure to satisfy the spending requirements of Treas. Reg. 1.148-7(e). [This is a “dangerous” election.]
  2. Election under Treas. Reg. 1.148-7(j) to treat a multipurpose issue as two separate issues (an apportionment election) such that one issue may qualify as a construction issue even if the other portion consists of a refunding issue.  Note, however, that the portion that is not treated as a construction issue can be eligible for the 6-month spending exception to rebate and not the 18-month exception.
  3. Election under Treas. Reg. 1.148-7(f)(2) to apply paragraphs (e) through (m) of Treas. Reg. 1.148-7 based on actual facts instead of issue-date reasonable expectations.  For instance, using this election, there would not need to be a reasonable expectation to spend 75% of the ACP on construction expenditures.