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:
- if they are allocated to an expenditure for a governmental purpose;
- 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;
- by retirement of the issue; or
- 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:
- Issuance costs or any qualified administrative costs;
- fees for qualified guarantees of the issue or payments for a qualified hedge for the issue;
- 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“);
- rebate amounts and other amounts paid to the United States;
- 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“);
- 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);
- 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.