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:
- Any issue the proceeds of which are spent within six months;
- 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;
- 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;
- 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);
- Proceeds invested in tax-exempt obligations;
- Proceeds invested in SLGS;
- 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.
- Each exception is independent (meaning, an issue may qualify under more than one exception);
- The exceptions are not mandatory (meaning, an issuer may pay rebate even if it actually complies with an exception);
- 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);
- A portion of a multipurpose issue properly allocable to a refunding purpose is treated as a separate issue (must make multipurpose allocation);
- 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
- 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:
- 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.
- 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.
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).
- 6-Month Exception: [See next heading]
- 18-Month Exception:
- 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.
- 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:
- 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.]
- 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.
- 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.