Basic Tax Definitions

July 18, 2011

Anti-Injunction Act is an act that prohibits federal courts from issuing an injunction against proceedings in any state court, except within three specifically described exceptions.  The “Tax Anti-Injunction Act” is codified in I.R.C. 7421(a) and provides that, with 14 specified exceptions, “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.”

Capital Appreciation Bonds, per MSRB definition, is “a municipal security on which the investment return on an initial principal amount is reinvested at a stated compounded rate until maturity. At maturity the investor receives a single payment (the ‘maturity value’) representing both the initial principal amount and the total investment return. CABs typically are sold at a deeply discounted price with maturity values in multiples of $5,000. CABs are distinct from traditional zero coupon bonds because the investment return is considered to be in the form of compounded interest rather than accreted original issue discount. For this reason only the initial principal amount of a CAB would be counted against a municipal issuer’s statutory debt limit, rather than the total par value, as in the case of a traditional zero coupon bond. See: COMPOUND ACCRETED VALUE. Compare: CURRENT INTEREST BOND; ZERO COUPON BOND.”

Capital expenditure means any cost of a type that is properly chargeable to capital account (or would be so chargeable with a proper election or with the application of the definition of placed in service under Section 1.150-2(c)) under general federal income tax principles.  For example, costs incurred to acquire, construct, or improve land, buildings, and equipment generally are capital expenditures.  Whether an expenditure is a capital expenditure is determined at the time the expenditure is paid with respect to the property. Future changes in law do not affect whether an expenditure is a capital expenditure.  See Section 1.150-1(b) of the Regulations.  (Siehe auch den Aufschrieb bezueglich capitalization fuer Raabe.)

Basis point is 100th of one percent (0.01%).  Basis points are referred to as “bips” or “bps.”  For illustration purposes, 45 bps is 0.45%, and 125 bps is 1.25%.  “A basis point (often denoted as bp or ‱; rarely, permyriad) is a unit relating to interest rates that is equal to 1/100th of a percentage point per annum. It is frequently but not exclusively used to express differences in interest rates of less than 1% pa. It avoids the ambiguity between relative and absolute discussions about rates. For example, a ‘1% increase’ from a 10% interest rate could refer to an increase either from 10% to 10.1% (relative), or from 10% to 11% (absolute).  It is common practice in the financial industry to use basis points to denote a rate change in a financial instrument, or the difference (spread) between two interest rates, including the yields of fixed-income securities. Since certain loans and bonds may commonly be quoted in relation to some index or underlying security, they will often be quoted as a spread over (or under) the index. For example, a loan that bears interest of 0.50% per annum above LIBOR is said to be 50 basis points over LIBOR, which is commonly expressed as ‘L+50bps’ or simply ‘L+50’.” (Wikipedia)

Exemplary vs. exclusionary lists: Section 7701(c) provides that the term “including” when used in a definition in Title 26 is not to be deemed to exclude other things otherwise within he meaning of the term defined.

Inquisitorial Income Tax is a tax on income that depends on the state’s ability to inquire into the taxpayer’s source of income and financial affairs.  The term seems to be used most often in connection with criticisms of the income tax.  See this article regarding characteristics of the “inquisitorial” income tax during the Civil War years.

Interest:  The case most often cited for the definition of “Interest” is the Supreme Court’s decision in Deputy v. du Pont.  Interest is “compensation for the use or forbearance of money.”  See David Garlock, Federal Income Taxation of Debt Instruments, 101.  Are commitment fees or standby charges “interest”?  No.  “Fees you incur to have business funds availability on a standby basis, but not for the actual use of the funds, are not deductible as interest payments.  You may be able to deduct them as business expenses.”  See IRS Publication 535.

Pigovian Tax” (also spelled, Pigouvian tax) is a tax applied to a market activity that is generating negative externalities (costs for somebody else). The tax is intended to correct an inefficient market outcome, and does so by being set equal to the negative externalities. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. An oft-cited example of such an externality is for environmental pollution.  (See Wikipedia.)

Placed in servicemeans, with respect to a facility, the date on which, based on all facts and circumstances, (1) the facility has reached a degree of completion which would permit its operation at substantially its design level; and (2) the facility is in fact in operation at such level.  See Treas. Reg. 1.150-2(c).  Note that the definition applies with respect to facilities only. Query whether you can use a placed in service date that is later than the issue date for equipment that does not become part of the facility.  It may be more conservative to apply the issue date as the placed in service date for such equipment (or furnishings).

Placed in service for purposes of the deduction for depreciation and investment tax credits, means the taxable year that the property is placed in a condition or state of readiness and available for a specifically assigned function. See Treas. Reg. secs. 1.46-3(d)(1)(ii) and 1.167(a)-11(e)(1)(i).

Pre-issuance accrued interest means amounts representing interest that accrued on an obligation for a period not greater than one year before its issue date but only if those amounts are paid within one year after the issue date.  See Section 1.148-1(b) of the Regulations.

Proceeds” for purposes of I.R.C. 142 means sale proceeds and investment proceeds – basically the same as how the term is used in I.R.C 148.  Therefore, if 95% of net proceeds must be spent for one purpose or another, use proceeds plus investment proceeds less the reserve fund.  For purposes of I.R.C. 141, however, see the special definition in Treas. Reg. 1.141-1(b).

Negative arbitrage is the “phenomenon of earning less than the bond yield.  If market conditions force a fund into a negative arbitrage position, the issuer will normally stand to benefit from blending that fund with some other fund that it can invest at positive arbitrage, generally using longer term investments.  The negative arbitrage in the short-term fund can shelter positive arbitrage in the long-term fund that would otherwise be subject to yield restriction or rebate.” (Ballard, ABCs of Arbitrage).

De Minimis is defined in Treas. Reg. 1.148-1(b) with reference to original issue discount or market discount.  For purposes of references to original issue discount, the second prong of the definition (“… plus (ii) any original issue premium that is attributable exclusively to reasonable underwriters’ compensation”) usually only applies in competitive transactions where the underwriter discount has been included in the bid calculation.  This second prong does not usually arise in negotiated transactions and can normally be disregarded in such negotiated transactions.

Pre-Ullman Bond” is a bond that was issued prior to the effective date of the Mortgage Subsidy Bond Tax Act.  There is an exemption from the 10-year rule for pre-Ulman bonds.  See Feldstein & Fabozzi, “Handbook for Municipal Bonds” for more information.

Depreciation” vs.Amortization – When a business purchases an asset, the life span of the asset is determined.  Each year, a business will determine the portion of the asset that is “used up” and allocate the cost of the asset over the life of the asset.  The IRS calles this “cost recovery.”  The reduction in the cost of the asset is recorded on the balance sheet.  If the asset is a tangible asset, this recording is referred to as “depreciation.”  If the asset is an intangible asset, the recording is referred to as “amortization.”  Cars are depreciated.  Patents are amortized.

Gross Negligence” vs. “Ordinary Negligence” – Negligence is a failure to exercise reasonable care.  The standard for ordinary negligence is the “reasonable person” standard, taking into account the circumstances of the person (i.e., if the wrongdoer is a professional, the “reasonable person” standard is based on what a reasonable person who is a professional would do).  Gross negligence, however, is reckless and willful misconduct.  A Supreme Court judge pointed out the extent of gross negligence versus “ordinary” negligence by saying, “even a dog knows the difference between being tripped over and being kicked.”

Real Estate Investment Trust” – (from Wikipedia) Under U.S. Federal income tax law, a real estate investment trust (REIT) /ˈrt/ is “any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages” under Internal Revenue Code section 856.[1]The rules for federal income taxation of REITs are found primarily in Part II (sections 856 through 859) of Subchapter M of Chapter 1 of the Internal Revenue Code. Because a REIT is entitled to deduct dividends paid to its owners, a REIT may avoid incurring all or part of its liabilities for U.S. federal income tax. To qualify as a REIT, an organization makes an “election” to do so by filing a Form 1120-REIT with the Internal Revenue Service, and by meeting certain other requirements. The purpose of this designation is to reduce or eliminate corporate tax, thus avoiding double taxation of owner income. In return, REITs are required to distribute at least 90% of their taxable income into the hands of investors. A REIT is a company that owns, and in most cases, operates income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and even timberlands. Some REITs also engage in financing real estate. The REIT structure was designed to provide a real estate investment structure similar to the structure mutual funds provide for investment in stocks

Tax Ownership” – See this posting for a description of what “ownership” means for federal income tax purposes.  A key component to tax ownership is the taxpayer’s residual risk value.  See CCA 201351022, Dec. 23, 2013, for a description of the residual risk value factor.

Exempt Facility Bonds (I.R.C. § 142)

July 14, 2011

General Matters:

Exempt facility bond means any bond issued as part of an issue 95 percent or more of the net proceeds of which are to be used to provide one of the following:

  1. Airports;
  2. Docks and wharves;
  3. Mass commuting facilities;
  4. Facilities for the furnishing of water;
  5. Sewage facilities;
  6. Solid waste disposal facilities;
  7. Qualified residential rental projects;
  8. Facilities for the local furnishing of electric energy or gas;
  9. Local district heating or cooling facilities;
  10. Qualified hazardous waste facilities;
  11. High-speed intercity rail facilities;
  12. Environmental enhancements of hydro-electric generating facilities;
  13. Qualified public educational facilities;
  14. Qualified green building and sustainable design projects; or
  15. Qualified highway or surface freight transfer facilities.

Note that, with certain exceptions, the basic rules applicable to all private activity bonds apply to exempt facility bonds.  These rules include:

  1. Volume cap rules under Section 146 (not applicable to airport exempt facilities);
  2. Substantial user requirement under Section 147(a);
  3. Limitation on maturity under Section 147(b);
  4. Limitation on use of proceeds to acquire land under Section 147(c);
  5. Prohibition for acquiring existing property under Section 147(d);
  6. Prohibition of certain “bad” uses under Section 147(e);
  7. TEFRA approval requirement under Section 147(f);
  8. Restrictions on costs of issuance under Section 147(g) (2% of sale proceeds);
  9. Official action requirements (adoption of an inducement resolution, for example);
  10. Arbitrage limitations; and
  11. Special change in use penalties under Sections 150(b) and (c).

Governmental Ownership Requirement (Sec. 142(b)):

(1) Certain facilities must be governmentally owned; and

(2) Limitation on office space.

There are special exempt facility bond rules set forth in Section 142(b) of the Code.  First, for several types of exempt facility bonds, the facilities must be “governmentally owned.”  The Code states that “a facility shall be treated as described in paragraph (1) (airports), (2) (docks and wharves), (3) (mass commuting facilities) or (12)(environmental enhancements of hydro-electric generating facilities) only if all of the property to be financed by the net proceeds of the issue is to be owned by a governmental unit.”

In paragraph (b)(1)(B), the Code provides for a safe harbor for leases and management contracts.  Under this safe harbor, if the facilities are leased to a non-governmental person, the bonds can still be exempt facility bonds if certain conditions are met:

  1. the non-governmental lessee makes an irrevocable election (binding on the lessee and all successors in interest under the lease) not to claim depreciation or an investment tax credit with respect to such property;
  2. the lease term (as defined in 168(i)(3)) is not more than 80% of the reasonably expected economic life of the property (as determined under section 147(b)); and
  3. the lessee has no option to purchase the property other than at fair market value (as of the time such option was exercised).

(Note that the 80% requirement is more conservative than under I.R.C. 467(b)(4)(A), which states that a disqualified leaseback or long-term agreement means any section 467 rental agreement if such agreement is part of a leaseback transaction or such agreement is for a term in excess of 75 percent of the statutory recovery period for the property.  A “section 467 rental agreement” is a rental agreement that has increasing or decreasing rents or deferred or prepaid rents.  Treas. Reg. 1.467-1.  If an agreement is a section 467 rental agreement, the lessor and the lessee must each take into account for any taxable year the sum of (1) the section 467 rent for the taxable year and (2) the section 467 interest for the taxable year.  Section 467, in other words, may be viewed as imputing a loan in certain non-level rent payment structures.  This mismatch in timing of payments and the receipts of any benefits relates to private loan analyses.)

In applying these rules, use by a non-governmental person includes use pursuant to any arrangement that allows use on a basis different from that available to the general public, such as leases, management contracts, service contracts and preferential-use agreements.

It should be noted that “ownership” and the status of an activity as a “lease” is determined under federal tax law, not state law.  Under federal tax law, ownership is determined based on substance over form. In other words, it does not matter what the intent of the parties is or what the documents are called – what matters is whether there is evidence that an activity should be considered ownership.  This substance over form approach determines whether a lessor really has sufficient property ownership of the asset involved or whether the lessor is really just a conditional seller, an option holder or a lender.

The Internal Revenue Code does not define what a real lease is.  Instead, case law provides the relevant rules.  The bottom line, as determined in Frank Lyon Company v. United States, 435 U.S. 561 (1978), is that, in considering tax ownership, and therefor true lease status, is to determine whether the lessor, rather than the lessee, is the equipment’s/property’s tax owner, having “significant and genuine attributes of the traditional lessor status.  What those attributes are in any particular case will necessarily depend upon its facts.”  See Richard M. Contino, Esq., “Understanding Tax Leases,” available online at

What this means is that a lease transaction between a bank and a city, for municipal trucks, should not necessarily be treated as a lease within the meaning of Section 142(b).  If the city actually operates the trucks and maintains them, for instance, the facts strongly suggest that federal tax law should treat this lease arrangement as actual ownership by the city.  This means, in turn, that the special rule in paragraph (b)(1) is met without the need to satisfy the safe harbor in subparagraph (b)(1)(B).

Note also that the AGL&F 50 State Survey has a good discussion of leases vs. ownership.  The publication explains that a “lease-purchase arrangement, conditional sale or purchase agreement […] is generally treated as a lease under state law, but as an installment sale and loan for federal tax purposes. […] For federal tax purposes, the city is both the buyer and new owner of the property and the borrower of a loan.”

See also PLR 201918008

Public Use Requirements of the Regulations:

The Code does not impose a public use requirement to qualify bonds as exempt facility bonds for airports.  However, the Regulations (Treas. Reg. 1.103-8(e)(1)) require that the facility must be available on a regular basis for general public use, or be part of a facility so used, as contrasted with similar types of facilities that are constructed for the exclusive use of a limited number of non-governmental persons in their trades or businesses.  A facility at a municipal airport, such as a terminal gate, baggage or cargo handling facility, qualifies as an exempt facility even if it is leased to or preferentially used by a non-governmental person; provided that the non-governmental person directly serves the general public as a common passenger carrier or freight carrier.  In addition, any other airport owned or operated for general public use is considered to be a facility for public use.

Airports, Docks and Wharves, Mass Commuting Facilities and High-Speed Intercity Rail Facilities (Sec. 142(c)):

Section 142(c) provides certain additional rules for airports, docks and wharves, mass  commuting facilities and high-speed intercity rail facilities.

Treas. Reg. 1.103-8(e)(2)(iv) provides that a mass commuting facility includes realty, improvements and personalty used to serve the general public commuting on a day-to-date basis by bus, subway, rail, ferry or other vehicles with prescribed routes.  Machinery, equipment, furniture and terminals are specifically mentioned in the regulations as “mass commuting facilities.”  In addition, a facility will qualify even if used by noncommuters and commuters.  Thus, a bus terminal used by a common carrier serving commuters and long-distance travelers qualifies as a mass commuting facility.

Treas. Reg. 1.103-8(e)(1) provides that the facility must be available for use by members of the general public or for use by common carriers or charter carriers who serve members of the general public.

Change in Use or Ownership:

Section 1.142-2 of the Regulations states that a change in use of a qualified facility from a qualifying to a non-qualified use will generally require that outstanding airport bonds be redeemed or defeased.

Section 150(b) of the Code states that a change in the use of a qualified facility from a qualifying to a non-qualifying use will also result in the denial of certain deductions to the users for any time the airport bonds remain outstanding until they are actually redeemed (e.g., in a defeasance situation).  For example, legislative history states that if a governmentally owned airport facility is converted to a private office building, each non-governmental tenant would be denied any rent deduction to the extent of bond interest payments allocable to that portion of the facility used by the tenant.

Section 150(c) of the Code states that change in the ownership of a facility in whole or part after issuance of the bonds will act to deny the new owner any deduction for interest paid by the new owner in connection with the facility for any time the airport bonds remain outstanding until actually redeemed.  Therefore, if the new owner assumes the bond debt, interest paid is not deductible.  In addition, if the bond debt is not assumed but remains outstanding and the owner incurs new debt in connection with the facility, deductions on the new debt may be denied to the extent of interest on the airport bonds accruing after acquisition.

Demolition is not change in use.  PLR 200928018: Bond-financed pollution control facilities sold to a new owner became subject to a consent degree and were demolished because the new owner determined the conditions imposed by the consent decree were not economical and as a result the property would not be used for anything other than scrap materials for recycling and the demolition contract provided there was no net scrap value.  PLR 201110007:  Demolition of the project facilities will not cause interest on the bonds to fail to be excludable from gross income and will not preclude the borrower from deducting interest where the facility was demolished due to an environmental law decree and uncertainty regarding the plant’s future fuel contracts and the salvage value net of decommissioning costs was negative.

Other Rules:

  1. Deep discount obligations:  The proceeds of any issue of exempt facility bonds includes any imputed proceeds of the issue.  The imputed proceeds of the issue equal the sum of the amounts of imputed proceeds for each annual period over the term of the issue.  But, there are no imputed proceeds if the obligation does not have a stated interest rate (determined on the date of issuance) that increases over the term of the obligation, and the purchase price of the obligation is at least 95% of its face amount.  See Treas. Reg. § 1.103-8(a)(6) and (a)(7).

Sewage Facilities:

PLR 8814017 (Jan. 4, 1988):  Ruling requested as to whether certain facilities proposed to be built by the company are “sewage facilities.”  Request was made under the provisions of Rev. Proc. 84-49, which provides procedures for the issuance of rulings under I.R.C. 103 when the requestor of the ruling is not the issuer of the prospective obligations.  The facilities consist of a pump station, an equalization tank and an anaerobic reactor that consists of a distribution system on the bottom of the reactor for the income effluent, a settling device to remove solids from the effluent and a methane gas collection system.  The facilities also include office space in a laboratory.  The sewage consists of process waters from rinsing and cleaning production equipment that is discharged into the sewer system and that is contaminated with soluble biochemical oxygen demand (“BOD”).

Electronic Signatures

July 8, 2011

Electronic Signatures in Colorado:

Colorado has enacted the Uniform Electronic Transactions Act in Article 71.3 of Title 24, Colorado Revised Statutes, as amended.  The Act provides for the enforceability electronic signatures in certain instances.

Sample Language:

Sample contract language might be:

(Electronic Signatures and Electronic Records) Party A consents to the use of electronic signatures by Party B.  This Agreement and any other documents requiring a signature hereunder, may be signed electronically by Party B in the manner specified by Party B.  Party A and Party B agree not to deny the legal effect or enforceability of this Agreement solely because it is in electronic form or because an electronic record was used in its formation.  Party A and Party B agree not to object to the admissibility of this Agreement in the form of an electronic record, or a paper copy of an electronic document, or a paper copy of a document bearing an electronic signature, on the grounds that it is an electronic record or electroni signature or that it is not in its original form or is not an original.

Or the following:

The parties agree that the electronic signature of a party to this Indenture shall be as valid as an original signature of such party and shall be effective to bind such party to this Indenture.  The parties agree that any electronically signed document (including this Indenture) shall be deemed (a) to be “written” or “in writing,” (b) to have been signed and (c) to constitute a record established and maintained in the ordinary course of business and an original written record when printed from electronic files.  Such paper copies or “printouts,” if introduced as evidence in any judicial, arbitral, mediation or administrative proceeding, will be admissible as between the parties to the same extent and under the same conditions as other original business records created and maintained in documentary form.  Neither party shall contest the admissibility of true and accurate copies of electronically signed documents on the basis of the best evidence rule or as not satisfying the business records exception to the hearsay rule.  For purposes hereof, “electronic signature” means a manually signed original signature that is then transmitted by electronic means; “transmitted by electronic means” means sent in the form of a facsimile or sent via the internet as a “pdf” (portable document format) or other replicating image attached to an e mail message; and, “electronically signed document” means a document transmitted by electronic means and containing, or to which there is affixed, an electronic signature.

Important Note:

A review of the Act and its application to particular contracts and transactions should be completed before relying on the provisions of the Act.  The author of this posting has not done this research for documents relating to tax-exempt bond transactions in Colorado or elsewhere.  This is particularly signficant if an attorney or law firm is to opine on the enforceability of the agreement in which the provision is included.

Matters concerning prison transactions

July 6, 2011

Noteworthy Articles:

Texas Prison Debt Gets Adverse Determination Letter,” The Bond Buyer of June 29, 2011

Allocation and Accounting Regulations; What can be financed with tax-exempt bonds; Proceeds-Spent-Last; Working Capital; Hedge Bonds

July 1, 2011

General Matters

See “Allocation and Accounting Regulations for Arbitrage Bonds” for a discussions of allocation of bond proceeds to expenditures.

The Code and accompanying regulations provide detailed rules for the proper allocation of bond proceeds to expenditures.  Despite this article’s emphasis on arbitrage and rebate, compliance with the allocation and accounting rules is critical for all aspects of tax-exempt bonds.  For example, the private activity bond regulations provide that for purposes of section 141, the arbitrage allocation rules apply.  Similarly, section 1.149(g)-1(b) provides that the arbitrage and accounting rules under section 1.148-6 also apply to hedge bonds.

Amounts cease to be allocated to an issue as proceeds or replacement proceeds only:

  1. if they are allocated to an expenditure for a governmental purpose;
  2. if proceeds, they are allocated to another issue as transferred proceeds, or if replacement proceeds, they are no longer used in a manner that causes those amounts to be replacement proceeds of that issue;
  3. by retirement of the issue; or
  4. upon application of the universal cap.

Treas. Reg. 1.148-6(d)(iii) requires that an issuer account for allocation of proceeds to expenditures not later than 18 months after the later of: (1) the date the expenditure is paid; or (2) the date that the project that is financed by the issue is placed in service.  In any event, the allocation must be made within 60 days after the fifth anniversary of the issue date or, if earlier, 60 days after the retirement of the issue.

See PLR 200924013 (Feb. 27, 2009): Initial allocation of tax-exempt bond proceeds to a sports facility, and a subsequent reallocation of the proceeds to a project financed by a later issue of taxable bonds.

See PLR 201435013 (Aug. 29, 2014): Initial allocation of build America bond and tax-exempt bond proceeds changed, but still within time frame.  There were sufficient proceeds of the bonds to which the expenditures were to be reallocated, and none of the bonds were no longer outstanding.

The current regulations in Treas. Reg. 1.148-6 were promulgated in 1993.

See PLR 200210006 (Sept. 28, 2001):  Extraordinary items.

What can generally be financed with tax-exempt bonds?

The items that may be financed with tax-exempt bonds are limited by state law and the rules of when an item is “spent” for federal income tax purposes.

A.  State Law Considerations:

A State or local bond within the meaning of Section 103 of the Code is an “obligation” of any State or political subdivision thereof.  For an obligation to exist, it must (among other things) be valid under State law.  State law may set parameters for what can be financed with an issue of bonds (or, in other words, how bond proceeds may be “spent” – which ties into the federal analysis described in B below).  The Colorado Health Facilities Authority Act at section 110 of article 25 of title 25, C.R.S., for example, limits the purposes for which bonds can be issued by the Colorado Health Facilities Authority to financing “all or a part of the cost of any health institutions or any facilities authorized by this article or for the refinancing of outstanding obligations.”  The CECFA Act at section 110 of article 15 of title 23, C.R.S., permits the issuance of bonds for the “purpose of financing all or a part of the cost of any facilities authorized by this article or for the refinancing of outstanding obligations.” “Facilities” includes a specified list of purposes relating to educational and cultural facilities.  Each of these permitted purposes are “governmental purposes,” as such term is further used throughout the Code.

B.  Allocation to Expenditures for purposes of the “spent” rules:

1.  “Hedge Bond” Context:  A bond is not a tax-exempt bond if it is a “hedge bond” within the meaning of the Code.  The Code considers all bonds to be “hedge bonds” from the very start unless: (a) the issuer reasonably expects that 85 percent of the spendable proceeds of the issuer will be used (“spent”) to carry out the governmental purpose of the issue (see discussion under A) within the 3-year period beginning on the issue date; and (b) not more than 50 percent of the proceeds of the issue are invested in nonpurpose investments having a substantially guaranteed yield for four years or more. Disregarding the second 50% prong which does not come into play very often, what this means is that a bond is tax-exempt (or at least not a hedge bond) so long as 85% of the spendable proceeds are used for the governmental purpose. Even if a bond turns out to be a “hedge bond,” it can still be a tax-exempt bond if the spendable proceeds are “spent” within the following timeframe:

  • 10 percent of the spendable proceeds of the issue must be spent for the “governmental purpose” (see description under A above) of the issue within the 1-year period beginning on the date the bonds are issued;
  • 30 percent of the spendable proceeds of the issue must be spent for such purposes within the 2-year period beginning on such date;
  • 60 percent of the spendable proceeds of the issue must be spent for such purposes within the 3-year period beginning on such date; and
  • 85 percent of the spendable proceeds of the issue must be spent for such purposes within the 5-year period beginning on such date.

In order to satisfy the 5-year hedge bond exception, the additional requirements of I.R.C. 149(f)(3) must also be met, which require that (1) payment of legal and underwriting costs associated with the issuance of the issue not be “contingent” and (2) at least 95% of the reasonably expected legal and underwriting costs associated with the issuance must be paid within 180 days of the date of issuance.  What does it mean to have “contingent” payments in this context? Contingency may arise if costs of issuance are payable after closing based on amount of purpose loans originated.  The issue of contingency frequently came up in pool bond issuances and related IRS audits. The burden of proving reasonableness with respect to the 5-year hedge bond exception is very high and has frequently been the focus of IRS audits involving pool bonds. “Spendable proceeds” is defined in Section 1.149(g)-1(a) as net sale proceeds.  Net sale proceeds are defined in Section 1.148-1 as sale proceeds, less the portion of those sale proceeds invested in a reasonably required reserve or replacement fund under Section 148(d) and as part of a minor portion under Section 148(e).  This indicates that moneys in a reserve fund do not need to be considered in testing the hedge bond rule. Question: What if a reserve fund (funded with bond proceeds) is dissolved many years after the issue date. Can those reserve fund moneys be properly used to finance a governmental purpose? 2.  Financing working capital expenditures:  Bond proceeds may be “spent” on working capital expenditures only to the extent that those working capital expenditures exceed “available amounts” as of the particular date. Note that proceeds in this context also includes replacement proceeds. (See Section 1.148-6(d)(3)(i).)  (In other words, one might think of the rule as stating that “one may use bond proceeds for working capital expenditures that exceed the available amounts.”) There are “de minimis” exceptions to the strict working capital expenditure rule for the following permitted expenditures:

  1. Issuance costs or any qualified administrative costs;
  2. fees for qualified guarantees of the issue or payments for a qualified hedge for the issue;
  3. 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 (“Capitalized Interest“);
  4. rebate amounts and other amounts paid to the United States;
  5. costs, other than those described previously, that do not exceed 5% of the sale proceeds of an issue and that are directly related to capital expenditures financed by the issue (e.g., initial operating expenses for a new capital project) (the “Other Working Capital Expenditure Exception“);
  6. principal or interest on an issue paid from unexpected excess sale or investment proceeds (“Excess Proceeds” – this is often referenced in the tax document or bond resolution vis-a-vis how excess proceeds are to be used);
  7. principal or interest on an issue paid from investment earnings on a reserve or replacement fund that are deposited in a bona fide debt service fund.  (See Section 1.148-6(d)(3)(ii)

Note: There is a 13-month temporary yield restriction period for “restricted” working capital, as further described in Treas. Reg. 1.148-2(e)(3).  Query whether this 13-month temporary period also applies to working capital that falls within the “de minimis” exception under Treas. Reg. 1.148-6(d)(3)(ii)(5). That type of “working capital” does not appear to be “restricted” working capital for purposes of the 13-month temporary period.  Should the 30-day temporary period apply instead? This matter needs further review.

With respect to the Other Working Capital Expenditure Exception, note the following: If the issue consists of a new money portion and a refunding portion, the 5% limitation must be calculated with reference to the new money portion and may not be based on the full issue sale proceeds. A certification in a tax certificate regarding such use of sale proceeds might be as follows: “An amount not to exceed $_______________ (i.e., an amount not greater than 5 percent of the proceeds received from the sale of the New Money Portion of the Series 20XX Bonds) may be allocated to working capital expenditures directly related to Capital Expenditures financed by the Series 20XX Bonds (including interest that accrues on the New Money Portion of the Series 20XX Bonds after the Project is Placed in Service).” (* 20120130)

Can capitalized interest be financed for advance refunding bonds? (* 201407031) In connection with a draw down loan, can a portion of each draw be used to pay capitalized interest?  Yes, but it may be appropriate to limit the use of draw proceeds to capitalized interest that accrues not later than three years from the initial draw (the issue date).  Capitalized interest may be permissible up to one year after the placed in service date, if later than the three-year period, but for large projects with multiple placed in service dates, it may be difficult to determine compliance with the one-year rule. Can “qualified administrative costs” for purposes of the working capital rule include ongoing trustee fees, issuer fees or rating agency fees paid from an account that is funded with bond proceeds at closing and maintained for, e.g., three years? Probably yes. 3.  Acquisition of outstanding stock of a corporation:  See PLR 8243092 and PLR 8605012.  (*20110602)

C.  Reallocation of Bond Proceeds

Tax rules on expenditures allow issuers to reallocate how they use bond proceeds within 18 months of when a bond-financed project was placed in service and no later than five years from when the bonds were issued.  (See also The Bond Buyer, BAB Audit Prompts Concern, October 26, 2011, reporting on reallocation of bond premiums in order to avoid loss of BABs status.)  The text of Treas. Reg. 1.148-6(d), which is the applicable regulation, states:

An issuer must account for the allocation of proceeds to expenditures not later than 18 months after the later of the date the expenditure is paid or the date the project, if any, that is financed by the issue is placed in service. This allocation must be made in any event by the date 60 days after the fifth anniversary of the issue date or the date 60 days after the retirement of the issue, if earlier.

See PLR 200924013:  “By not requiring allocations to be determined when the expenditure is paid or incurred, the regulations acknowledge that day-to-day practicalities require some flexibility for when issuers must make allocations.  We conclude that these practicalities also require flexibility to change allocations, so long as those changes are made within the time frame provided under Treas. Reg. 1.148-6(d)(1)(iii).” See also TAM 9723012: “May Authority and Hospital, after allocating proceeds through reimbursements made in their documents, set aside those allocations when it is later established that certain of those proceeds are allocated to expenditures used in a trade or business carried on by a person other than a 501(c)(3) organization or governmental unit?” No, once allocation made, the allocation is binding.  See reference here. The Treas. Reg. 1.148-6 allocation timing rules do not apply to taxable bonds, which means an allocation after the timing deadline can still be reasonable for taxable bonds.  See 1.141-6(a)(5) and consider facts and circumstances to determine whether the allocation would conflict with prior allocations or other evidence of prior determination of how taxable bond proceeds were intended to be used.

D.  Working Capital; Proceeds-Spent-Last

Private Letter Ruling 200446006:  Section 148 — Arbitrage Bond Restrictions; Section 103 — Tax-Exempt Interest.  Issue: How does the “proceeds-spent-last” allocation rule set forth in Treas. Reg. 1.148-6(d)(3)(i) apply to proceeds of the Series C Deficit Bonds (which are expected to be tax-exempt bonds)? The PLR recites that the State funds employment benefits by imposing a tax on employers within the state (State Unemployment Tax).  If in the preceding year the balance in the state’s unemployment trust account (Trust Account) in the Federal Unemployment Trust Fund is less than a state-determined minimum, the state imposes an additional “deficit” tax on its employers.  Due to economic downturns, the state’s Trust Account has been depleted.  The state expects to issue bonds to pay benefit obligations – by deposit to the Trust Account. There will be three series of bonds.  The B and D series bonds will be taxable bonds the proceeds of which will be deposited to the Trust Account for several years until used to pay benefit obligations – this deposit will satisfy the floor amount and avoid imposition of the deficit tax rate.  The C series bonds would be issued as tax-exempt bonds – and the issuer would expect to spend the proceeds within six months after the date of issuance. (The C series of bonds were already issued as taxable bonds, but the state would like to reissue them as tax-exempt bonds subject to the outcome of the PLR.) The PLR recites the replacement proceeds rules of Treas. Reg. 1.148-1(c)(1).  If an issuer that does not maintain a working capital reserve borrows to fund a working capital reserve, the issuer will have replacement proceeds.  There is an exception in Treas. Reg. 1.148-1(c)(4)(ii) which provides that no replacement proceeds arise if all of the net proceeds of the issue are spent within 6 months of the issue date. Treas. Reg. 1.148-6(d)(3)(i) states that “proceeds of an issue may only be allocated to working capital expenditures as of any date to the extent that those working capital expenditures exceed available amounts as of that date (i.e., the “proceeds-spent-last” method).  Proceeds include replacement proceeds described in Treas. Reg. 1.148-1(c)(4). “Available amount” includes any amount that is available to an issuer for working capital expenditure purposes of the type financed by the issue.  Except as otherwise provided, available amount excludes proceeds of the issue, but includes cash, investments and other amounts held in accounts or otherwise by the issuer or a related party if those amounts may be used by the issuer for working capital expenditures of the type being financed by an issue without legislative or judicial action and without a legislative, judicial or contractual requirement that those amounts be reimbursed. A reasonable working capital reserve is not an “available amount” for this purpose.  See Treas. Reg. 1.148-6(d)(3)(iii)(B), which states “a reasonable working capital reserve is treated as unavailable.  Any working capital reserve is reasonable if it does not exceed 5% of the actual working capital expenditures of the issuer in the fiscal year before the year in which the determination of available amounts is made.  For this purpose only, in determining the working capital expenditures of an issuer for a prior fiscal year, any expenditures (whether capital or working capital expenditures) that are paid out of current revenues may be treated as working capital expenditures.  The IRS has addressed the 5% rule in Technical Advice Memorandum 200413012 (which attempts to clarify that the base for the 5% limit includes all working capital expenditures of the issuer in the prior fiscal year, including those working capital expenditures paid from the issuer’s restricted funds that otherwise were not treated by the issuer as available). Treas. Reg. 1.150-1(b) defines the term “working capital expenditure” as any cost that is not a capital expenditure.  Generally, current operating expenses are working capital expenditures.  Capital expenditures means any cost of a type that, under general federal income tax principles, is properly chargeable to a capital account or would be so chargeable with a proper election. The IRS concludes that the proceeds of the series B, C and D bonds that are used to pay benefit obligations are used for working capital expenditures.  The IRS also confirms that the proceeds of the series C bonds will not be available amounts vis-a-vis other proceeds of the series C bonds.  However, the question is whether the proceeds of the series B and D bonds are available amounts vis-a-vis the proceeds of the series C bonds. The state argues that the B and D bond proceeds are not “available amounts” because the state has an obligation to repay those amounts.  Thus, they are not available for the “proceeds-spent-last” rule.  The IRS disagrees with this claim, but states that a portion of the proceeds *can* be considered “unavailable” for other reasons.  Specifically, the IRS states that proceeds used to fund up to the “floor amount” of the Trust Account constitute a working capital reserve for purposes of expenditures from the state’s Trust Account. In conclusion, the IRS holds that, based on the facts, the proceeds of the series B and D bonds (but only to the extent that they are allocated to funding the floor amount) are not “available amounts” of the series C bonds for purposes of determining whether proceeds of the series C bonds are spent under the proceeds-spent-last method.  All remaining proceeds of the series B and D bonds do constitute “available amounts.” See the December 2004 Public Finance Update by Chapman & Cutler for another summary of this private letter ruling.  See also this Squire Sanders publication concerning working capital financings.  In the Squire Sanders publication, the author states that the draft ABA comments for guidance recommend that proceeds of an issue (taxable or tax-exempt) not be treated as available amounts with respect to the issue of which they are proceeds or with respect to any other issue.

Private Letter Ruling 200846018:   “Self-imposed restrictions on the use of the Fund is a transaction entered into for a principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of Section 148.”

Notes concerning calculation of maximum working capital financing:

  • Step 1: Basic maximum amount:  Don’t finance more than the maximum deficit, but take into account the lesser of 5% of prior year disbursements or average prior year cash balance.  Comes from Treas. Reg. § 1.148-6(d)(3)(iii), but incorporates replacement proceeds “average prior year cash balance” concept.
  • Step 2: Temporary period:  Issuer gets the 2-year/maturity or 13-month temporary period.  Treas. Reg. § 1.148-2(e)(3).
  • Step 3: Spending exception:  Six-month (90% of CCFD) or small issuer exceptions can apply.  See I.R.C. § 148(f)(4)(B)(iii).
  • Step 4:  Replacement proceeds:  Reserve balance may be treated as spent only up to the average prior year cash balance.  Comes from Treas. Reg. § 1.148-1(c)(4)(ii).
  • Under the September 2013 regulations, the average prior year cash balance test goes away, and only the 5% test stays.
  • In order to do a working capital financing, should be able to prove up deficits without taking into account any adjustments.

E.  Questions and Answers

  • Can the cost of rating agency report be paid with bond proceeds:  Assume a hedge (not a qualified hedge) relating to a particular series of prior bonds requires (as a condition to not automatically terminated) that all debt of the borrower be rated by two rating agencies, and assume that a future series of bonds is being issued.  In accordance with the hedge, the borrower must now get a rating for the new series of bonds.  The rating is not, however, a condition to issuance of this new series of bonds.  Can the rating agency fee be paid from the proceeds of the new series of bonds?  There are two issues to address, assuming the payment would be legal under state law regarding use of bond proceeds: (1) Is it an issuance cost of the new bonds or a qualified administrative cost; (2) Does it fall within the 5% exception or any other exception?
    • The cost is likely not within the scope of the 5% exception – it is not related to any capital expenditure of the new series of bonds.
    • It is also not a cost of issuance of the new series of bonds. It is probably not “connected with” or “allocable to” the new issue within the meaning of Section 147(g).  It also does not appear to be a qualified administrative cost within the meaning of 1.148-5(e)(2)(i), in that the cost does not relate to a nonpurpose investment.  There also does not appear to be a connection to the term ‘qualified administrative cost’ within the meaning of -5(e)(3) either.
    • Conclusion: ____________________.
  • Working Capital Financings:  For a good summary of the rules concerning working capital financings, and the exceptions to the proceeds-spent-last rule in Treas. Reg. 1.148-6(d)(3), see this Squire Sanders publication.