Section 148(f)(6)(A) of the Code defines a “nonpurpose investment” as any investment property which (a) is acquired with the gross proceeds of an issue and (b) is not acquired in order to carry out the governmental purpose of the issue.
Nonpurpose investments are investment securities such as treasury bonds, bank deposits or privately negotiated guaranteed investment contracts. Gross proceeds (for arbitrage rebate purposes) are allocated to “nonpurpose investments” until they are spent (i.e., allocated to expenditures). As Ballard explains, nonpurpose investments “are distinguished from ‘purpose investments,’ such as a loan of the proceeds of an issue of 501(c)(3) bonds to a hospital.” (See ABCs of Arbitrage, Frederic L. Ballard, Jr.)
Nonpurpose investments are subject to the basic yield restriction and arbitrage rules applicable to proceeds generally.
Purchase of investments: An issuer may not allocate gross proceeds to a nonpurpose investment at a price in excess of FMV. This requirement is intended to prevent an issuer from purchasing an investment at an artificially high price and diverting arbitrage into the hands of the seller (e.g., see concept of yield burning).
Sale of investments: In addition, an issuer that sells a nonpurpose investment may not allocate a small amount of gross proceeds to the receipt from the sale of such invesment than the FMV of the investment on the date of the sale. The same policy reasoning applies as with purchases of nonpurpose investments.
There are three safe harbor categories of investment set forth in the regulations that assist in the FMV determination:
- Securities traded on an established market;
- Certain guaranteed investment contracts purchased using the “three-bid” safe harbor; and
- Certain certificates of deposit.
Investments in tax-exempt securities are not considered nonpurpose investments. This exclusion thus permits an issuer to avoid yield restriction or rebate by investing its proceeds solely in tax-exempt bonds. There is a special rule regarding use of AMT bond proceeds or proceeds of a non-AMT bond invested in tax-exempt securities that either are or are not subject to AMT, which may cause the investment to be treated as “investment property” under Section 148(b)(2) of the Code nonetheless. See Section 148(b)(3)(B) of the Code.
Treas. Reg. 1.148-1(b) defines a “purpose investment” as an investment that is acquired by an issuer to carry out the governmental purpose of an issue. Ballard describes that the classic example of a purpose investment occurs in the financing using a qualified small issue of private activity bonds under Section 144(a) of the Code. Here, the issuer uses the proceeds of the bonds to make a loan to the business corporation which is to use the proceeds of the loan to acquire or construct facilities. The corporation’s loan payments are used by the issuer to pay debt service on the bonds. Under state law, this type of financing is often cast as a type of sale or lease of the facilities for a purchase price or rent equal to the amount necessary to enable the issuer to pay the bond interest and principal. Some states also explicitly allow the transaction to take the form of a loan.
The arbitrage rules treat the loan (or lease or sale agreement) as a purpose investment of the bond proceeds. Other examples of purpose investments are loans of 501(c)(3) qualified bond proceeds, qualified mortgage bonds, veterans’ bonds, student loan bonds.
Purpose investments are divided into various classes. Each class has its own definition of what a “materially higher” (for purposes of Section 148(a) of the Code) yield is. The following summarizes each “materially higher” definition by class:
- Purpose investments not qualifying for a special rule: 0.125% permitted spread
- Qualified mortgage loans, financed by qualified mortgage bonds or qualified veterans’ mortgage bonds: 1.125% permitted spread
- Program investments other than qualified mortgage loans or qualified student loans: 1.500% permitted spread
- Qualified student loans, financed by qualified student loan bonds: 2.000% permitted spread
- Tax-exempt loans to other municipalities: No limit
Earnings on purpose investments are free from the rebate requirement, but not yield restriction.
A special category of purpose investments is called “program investments.” Program investments qualify for a special definition of “materially higher,” as described above. Certain requirements set forth in Treas. Reg. 1.148-1(b) must be met for a purpose investment to be considered a program investment. Some bond counsel have taken the position that the issuer and conduit borrowers do not need to be restricted from purchasing the bonds later – at some time after the issuance of the bonds. Instead, the issuer and conduit borrowers simply may not purchase the bonds at original issuance. This appears to be contrary to the language in the regulations broadly preventing the purchase of such bonds.
Calculating the Purpose Investment Yield:
An issuer may make deductions for some of its costs in calculating yield of some types of purpose investments. This means such costs can be “recovered” from payments received on the purpose investment. There are four rules:
- For all purpose investments (but not qualified mortgage loans): Issuer may deduct issuance costs and PV of any estimated costs of “carrying or repaying” the issue, such as trustee fees. This rule allows a recovery of the issuer’s costs of issuance from the payment to it on the purpose investment, in addition to the permitted spread.
- For all purpose investments (but not qualified mortgage loans or program investments): [To come]
- For program investments and qualified student loans: Issuers cannot deduct loan costs if they use the 1.5 % or 2% permitted spreads (depending on purpose investment type). The thought is that the permitted spread is so large that the issuer does not need an additional deduction. But, the issuer can deduct the loan costs if the issuer waives the permitted spread. See Ballard’s example on page 120 of the 2011 ABC’s.
- For qualified mortgage loans: [To come]
[More to come as needed]