Universal Cap and Limits on Allocation of Proceeds to an Issue, Generally

April 30, 2012

General:

Context: It may not be evident for arbitrage rebate purposes what amounts constitute the proceeds of an issue.  The “one issue’ and ‘universal cap” accounting rules have therefore been developed, mainly in the advance refunding context, to clarify this matter.  The issue frequently comes up in advance refundings because of the presence of two issues and potentially two sets of proceeds.

One Issue Rule:

[To come]

Universal Cap:

The regulations impose a universal cap on the total amount of nonpurpose investments that can be allocated to an issue as proceeds:  The total of allocated nonpurpose investments on any computation date cannot exceed the total present value of the bonds (generally, equal to their outstanding face amount but probably with corrections for OID and OIP).  “Simply stated, this rule limits the amount of nonpurpose investments allocable to an issue to the value of outstanding bonds.  The value of all outstanding bonds is referred to as the universal cap.  Therefore, if the value of outstanding bonds is $20,000,000, the amount of nonpurpose investments that may be allocated to the issue is limited to $20,000,000.”  See “Allocation and Accounting Regulations for Arbitrage Bonds“.

The effect of the universal cap is to confirm that an issue cannot have proceeds after the issuer has retired it!

As stated by the IRS manual,

Section 1.148-6(b)(2)(ii) provides the general rule that amounts that would otherwise be gross proceeds allocable to an issue are allocated to the issue only to the extent the value of nonpurpose investments allocable to those gross proceeds does not exceed the value of all outstanding bonds of the issue. For purposes of the universal cap, nonpurpose investments include gross proceeds allocable to cash, tax-exempt bonds that would be nonpurpose investments, qualified student loans, and qualified mortgage loans.

Assume that an issuer uses tax revenues to pay off a bond issue that has unspent proceeds. The universal cap means that the unspent proceeds cease to be allocated to the bond issue.  Instead, they are treated as if they had been acquired with the revenues that retired the bonds.  Thus, because they are “investments” acquired with revenues, the issuer can invest them without yield restriction, liability for rebate or any adverse effect on the tax exemption of the retired bond issue.

As the issuer retires an issue, there will be less ‘room’ under the cap for investments.  Thus, if the amount of the issuer’s investments to which proceeds have been allocated is greater than the remaining outstanding amount of the issue, the effect of the cap will cause proceeds to ‘deallocate’ from the issue.  The ordering rule under the cap provides for deallocation of amounts in the following order:

  1. Replacement proceeds;
  2. Transferred proceeds; and then
  3. Sale proceeds and investment proceeds.

As provided in the IRS manual linked above:

Since these rules are often difficult to apply in the abstract, the practical effect of the universal cap may best be illustrated with a refunding example. Assume that City A issues bonds to advance refund a prior issue and places the proceeds in a refunding escrow. Assume also that City A uses revenues to establish a reserve fund. Generally, the reserve fund would constitute replacement proceeds of the refunding issue. However, the universal cap prevents allocation of the replacement proceeds (the reserve fund) to the issue until sufficient original proceeds and transferred proceeds have been expended to fall below the universal cap. This rule proves very beneficial where the proceeds of the reserve fund are invested at high yields, which is often the case.

The universal cap rules were implemented in the 1989 regulations and subsequently amended in 1991.

The following example from “Allocation and Accounting Regulations for Arbitrage Bonds” is helpful to an understanding of the universal cap rule:

Assume that City A issues bonds to advance refund a prior issue and places the proceeds in a refunding escrow.  Assume also that City A uses revenues to establish a reserve fund. Generally, the reserve fund would constitute replacement proceeds of the refunding issue. However, the universal cap prevents allocation of the replacement proceeds (the reserve fund) to the issue until sufficient original proceeds and transferred proceeds have been expended to fall below the universal cap. This rule proves very beneficial where the proceeds of the reserve fund are invested at high yields, which is often the case.

How does the reapplication of the universal cap rule work?  In connection with student loans, the reapplication might occur if loans securing an issue repay faster than bonds are retired, making room under the cap for additional gross proceeds.


Rebate Requirement (I.R.C. 148(f))

April 29, 2012

General Matters

Section 148(f) requires that issuers rebate certain excess earnings on proceeds of tax-exempt bonds to the federal government.

Rebate Calculation

Even if the issuer is permitted to earn a higher yield under the yield restriction rules and related exceptions, the arbitrage profit from investments must be paid, or “rebated,” to the Treasury Department.  The future value method is used to determine the amount that must be rebated, as follows:

  1. Identify dates and amounts of payments for and receipts from each investment of gross proceeds during the computation period ending on the computation date;
  2. Future value those amounts by assuming that interest is earned and compounded over the period to the computation date at a rate equal to the bond yield;
  3. If the future value of the actual receipts on the investments (earnings, sales, maturities) exceeds the future value of the payments (purchase prices) calculated in step 2 above, that excess is the rebate amount.

By “future valuing” at the bond yield, if the issuer’s actual rate of return is lower than the bond yield, the future value of the receipts will not be greater than the future value of the payments, so no rebate will be owed.  This is referred to as “negative arbitrage.”

Computation Date Credit:

Section 1.148-3(d)(1)(iv) of the Regulations provides a rebate credit of $1,000, adjusted annually after 2007.  The computation date credit for bond years ending 2013 is $1,590, according to Rev. Proc. 2012-41.  The credit for bond years ending 2014 is $1,620, according to Rev. Proc. 2013-35.

Proposed Regulations Modifying Arbitrage Regulations:

See Proposed Regulations Modify Arbitrage Regulations (by Jones Day) for a good summary of the proposed regulations.

Penalty in Lieu of Loss of Tax Exemption

A taxpayer cannot appeal TEB’s decision to not waive the penalty imposed under I.R.C. 148(f)(7) for failing to pay arbitrage rebate according to regulations.  See CCA 201539029 (Oct. 1, 2015)


Unrelated Trade or Business (I.R.C. 513)

April 29, 2012

General:

IRS materials frequently recite substantially the following law concerning unrelated trade or business matters:

Section 511 (a)(1) of the Code imposes a tax on the unrelated business taxable income of organizations described in section 501(c).

Section 512(a)(1) of the Code provides that the term “unrelated business taxable income” [UBTI] means the gross income derived by any organization from any unrelated trade or business [-> See 1] (as defined in section 513) regularly carried on [-> See 3] by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business, both computed with modifications provided in section 512(b).

Section 512(b)(5) of the Code provides, in pertinent part, that there shall be excluded from the computation of unrelated business taxable income all gains and losses from the sale, exchange, or other disposition of property other than: (A) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or (B) property held primarily for sale to customers in the ordinary course of the trade or business [-> See 4].

[1 (“Derived from Unrelated Trade or Business”) ==>] Section 1.513-1(d)(1) of the regulations provides that gross income derives from “unrelated trade or business,” within the meaning of section 513(a), if the conduct of the trade or business which produces the income is not substantially related (other than through the production of funds) to the purposes for which exemption is granted. The presence of this requirement necessitates an examination of the relationship between the business activities which generate the particular income in question-the activities, that is, of producing or distributing the goods or performing the services involved-and the accomplishment of the organization’s exempt purposes.

Section 513(a) of the Code provides, in pertinent part, that the term “unrelated trade or business” means, in the case of any organization subject to the tax imposed by section 511, any trade or business the conduct of which is not substantially related [-> See 2] (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 (c) (3).

[2 (“Substantially” and “related”) ==>] Section 1.513-1 (d) (2) of the regulations provides, in pertinent part, that a trade or business is “related” to exempt purposes only where the conduct of the business activities has a causal (see TAM 200047049) relationship to the achievement of exempt purposes (other than through the production of income).

Further, it is “substantially related,” for purposes of section 513, only if the causal relationship is a substantial one. For this relationship to exist, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of exempt purposes. Whether such activities contribute importantly to such purposes depends, in each case, upon the facts and circumstances involved.

Section 1.513-1(d)(3) of the regulations provides, in pertinent part, that in determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function, which they purport to serve. [Facts and circumstances test, as the IRS explains in TAM 200047049]

Section 1.513-1 (d) (4) (iii) of the regulations states that in certain cases, an asset or facility necessary to the conduct of exempt functions may also be employed in a commercial endeavor. In such cases, the mere fact of the use of the asset or facility in exempt functions does not, by itself, make the income from the commercial endeavor gross income from related trade or business. The test, instead, is whether the activities productive of the income in question contribute importantly to the accomplishment of exempt purposes.

Rev. Rul. 55-449, 1955-2 C.B. 599, states that the construction and sale of 80 houses by a foundation described in section 501 (c)(3) of the Code over a period of 18 months for the sole purpose of raising funds for the support of a church constitutes unrelated trade or business within the meaning of section 513, notwithstanding the fact that the organization did not plan to engage in further similar activities.

Rev. Rul. 78-98,1978-1 C.B. 167, states that income derived by a Code section 501(3) school from the use of its ski facilities by students is not income from an unrelated trade or business. However, income that the school receives from the general public is income from an unrelated trade or business.

PLR 201426029 (Jul. 1, 2014):  Income received by an exempt organization from activities of its testing laboratory was not unrelated business taxable income (UBTI) under I.R.C. 511.  The organization, which was exempt from tax under I.R.C. 501(c)(6) (Business League), was the subsidiary of a parent organization that was also exempt under I.R.C. 501(c)(6).  The parent’s purpose was to create and maintain quality standards applicable to entire industries.  The subsidiary was formed to conduct the testing and listing activities of the parent.  Its main activities included a certification process by which it reviewed laboratory tests of products to be certified, physically inspected the products and physically inspected the plans where the products were made.  Although the subsidiary conducted a trade or business for which it received fees, the revenue from that business was related to the organization’s exempt purpose.

[3 (“Regularly Carried On”) ==>] Section 1.513-1(c)(1) of the regulations provides, in pertinent part, that in determining whether trade or business from which a particular amount of gross income derives is “regularly carried on” within the meaning of section 512, regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued.  This requirement must be applied in light of the purpose of the unrelated business income tax to place exempt organization business activities upon the same tax basis as the nonexempt business endeavors with which they compete.  Hence, for example, specific business activities of an exempt organization will ordinarily be deemed to be “regularly carried on” if they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.

[4 (“Trade or Business”) ==>] Section 513(c) of the Code provides, in part, that the term “trade or business” includes any activity which is carried on for the production of income from the sale of goods or the performance of services.

Section 1.513-1(b) of the regulations provides, in pertinent part, that any activity of a section 511 organization which is carried on for the production of income and which otherwise possesses the characteristics required to constitute “trade or business” within the meaning of section 162 – and which, in addition, is not substantially related to the performance of exempt functions – presents sufficient likelihood of unfair competition to be within the policy of the tax. Accordingly, for purposes of section 513 the term “trade or business” has the same meaning it has in section 162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services.

In Brown v. Commissioner, 143 F2d 468 (5th Cir. 1944) a taxpayer owned 500 acres of
unimproved land used for grazing purposes. The taxpayer subdivided the land into lots and made improvements such as streets, storm sewers, and gas and electric lines. Each year approximately 20 to 30 lots were sold. The court held that the taxpayer was holding lots for sale to customers in the regular course of business.

Louisiana Credit Union League v. United States, 693 F.2d 525 (5th Cir. 1982) presents an extensive definition of the concept of unrelated trade or business. Although the finding of a profit motive is a key element, section 513(c) of the Code clearly states that any activity carried on for the production of income constitutes a trade or business.

Note that gain/loss from a sale, exchange, disposition of property is not considered in calculating UBTI unless the gain/loss is from, essentially, inventory or property held primarily for sale to customers in the ordinary course of a trade or business.

Based on the above quotes, gross income of an exempt organization is includible in the computation of UBTI if (see Treas. Reg. 1.513-1(a)):

  1. It is from an unrelated trade or business;
  2. Such trade or business is regularly carried on by it; and
  3. The conduct of such trade or business is not substantially related (other than through the production of funds) to the organization’s performance of its exempt function.

Discussion:

In TAM 200047049 (see below), M classified its income received from students as non-taxable exempt purpose income and from non-students as taxable income, relating to the use of the golf course.  The IRS agreed that this classification is appropriate in that the golf course is part of the educational and developmental experiences offered by M to its students, and student use of the golf course (and the other facilities) serves the objective of providing such experiences and contributes importantly to the exempt purposes of M.  The IRS further agreed that use by non-students did not serve this objective and did not further the overall educational purposes (since the non-student users were not students).

Re: Causal Relationship: In TAM 200047049, the IRS found that there was no “substantial causal” relationship between the land sales and the provision of educational services by M, in particular because M did not select buyers based upon their anticipated involvement in its activities. Instead, the sole criterion appears to be the amount of the buyer’s offer.  Thus, it appears one must ask “what are the criterions used by taxpayer for engaging in the activity?” – if the criterions have nothing or little (see TAM) to do with the exempt purpose, this indicates there is a lack of causal relationship.  Even if there is any connection, it would be so ancillary to the principal purpose.

Re: Profit Motive and Trade or Business: In TAM 200047049, the IRS held that the provision by M of municipal-type services was not substantially related to M’s exempt purposes in part, because they were not important (contribute importantly) to the educational and cultural exempt activities of M.  BUT, notwithstanding, the activity did not rise to the level of a trade or business because M had no profit motive in undertaking the activity – it was shown that the fees M received from this activity were far less than the expenses in incurred in providing them.  In other words, M had no profit motive in engaging in the services and, therefore, this was not a “Trade or Business.”

Questions and Answers:

Question 1: For purposes of avoiding “tax-exempt use property” status, and in order to take advantage of the unrelated trade or business exception, in section 168(h) of the Code, can “unrelated trade or business” use be elected by, e.g., an otherwise tax-exempt university?  Answer: [To come!]

Resources:

Technical Advice Memorandum 921102 (September 30, 1991): Addresses: (1) Whether school is operating for exclusively educational purposes within the meaning of section 501(c)(3) of the code; (2) whether the school meets the definition of an educational organization under section 170(b)(1)(A)(ii) of the code; (3) if the school is operating in accordance with section 501(c)(3) of the code, whether the school’s contracts with foreign governments constitute unrelated trade or business activities within the meaning of section 513(a) of the code.

Priv. Ltr. Rul. 199905027 (November 3, 1998): Requesting rulings that: (1) M’s (an organization created to administer programs of student financial assistance and for other matters) activities pursuant to a certain contract with state education assistance authority (“N”) for a state savings fund (“O”) are substantially related to M’s exempt purposes to not adversely affect M’s exempt status under section 501(c)(3) of the code; (2) income earned by M pursuant to such contract is not subject to tax under section 513 of the code (unrelated trade or business tax); (3) M meets the requirements as a supporting organization within the meaning of section 509(a)(3) of the code; (4) [other matters not relevant to this posting].

Technical Advice Memorandum 200047049 (August 2, 2000): (1) Whether income derived by 501(c)(3) organization (“M”) (which operates some type of “commune” or historical town) from the sale of land constitutes unrelated business taxable income under section 512(a)(1) of the code; (2) whether M’s provision of municipal-type services in the manner described serves the private interests of M’s members in contravention of section 501(c)(3) of the code, and, if not, whether income derived by M from providing such services constitutes unrelated business taxable income under section 512(a)(1); (3) whether income derived by M from the provision of a golf course, tennis court and boating facilities constitutes unrelated trade or business taxable income under section 512(a)(1) of the code, and what factors are relevant in determining whether such activities further an exempt purpose under section 501(c)(3); (4) if any of the above-mentioned activities constitute unrelated trade or business under section 513 of the code, whether such activities adversely affect M’s tax-exempt status under section 501(c)(3) of the code.

PLR 201603032 (Oct. 9, 2015):  Exempt organization that directly or indirectly builds, develops, finances, purchases, rehabilitates, owns, sells and operates affordable housing for persons of low or moderate income including but not limited to elderly persons with a need for housing, health care, financial security and assisted living.  The organization has an investment in and is a managing member of LLC.  LLC operates the affordable housing project hat qualifies for low income housing credits under I.R.C. 42.  Operation of the project is LLC’s only activity.   Will the rental income the organization derives from the LLC after the organization’s acquisition of additional membership interests in LLC (which will result in organization owning 100 percent of LLC) constitute unrelated business income subject to unrelated business income tax?  Will organization’s acquisition of additional membership interests in LLC constitute a recapture event under I.R.C. 42(j) for the low income housing tax credit allocable to the LLC?  Will the organization’s acquisition of additional membership interests in the LLC subject the organization to excess business holdings tax under I.R.C. 4943?  Will the project operated by the LLC, the activities of which will be attributed to the organization, meet the safe harbor in Rev. Proc. 96-32  and will continue to do so after the organization’s acquisition of all of the membership interests in the LLC, and will these activities therefore further the charitable purpose of relieving the poor and distressed under I.R.C. 501(c)(3) and the regulations thereunder?

(* 20110414)


Circular 230

April 24, 2012

General Background:

Certain of the matters discussed herein are borrowed from “Fundamentals of Municipal Bond Law 2008” published by the National Association of Bond Lawyers.  Circular 230 includes rules governing the practice of representatives before the Treasury Department, including the provision of tax advice relating to tax shelters.  They are referred to as “Circular 230” rules because they are published by the Treasury Department in a booklet of that name.  A practitioner may be censured, suspended or disbared from practice before the IRS if the practitioner fails to comply with the Circular 230 rules.

The Circular 230 rules were amended in 1984 to include rules relating to “tax shelter” arrangements.  Municipal bonds were excluded from the application of those rules. There has been subsequent development relating to exclusion of municipal bonds:

  1. 2003: The Treasury Department proposed changes that would make the rules generally applicable to municipal bonds.  See 68 Fed. Reg. 75186 (Dec. 30, 2003).
  2. April 2004: Based on input from the municipal bond community, in Announcement 2004-29 (Apr. 26, 2004), the Treasury Department stated that any final regulations would “not apply, if at all, to written advice concerning municipal bonds rendered less than 120 days after the publication of final regulations.”
  3. December 2004: The Treasury Department published final regulations under Circular 230 as well as special proposed regulations relating to municipal bond opinions that were intended to take into account the “unique characteristics” of the municipal bond market.
  4. May 2005: The final regulations (not the 2004 proposed regulations relating to municipal bonds) were amended in minor respects.
  5. June 2005: The IRS issued Notice 2005-47, which expanded the “State or local bond” definition to include all opinions relating to the tax-exempt status of bonds (not just those rendered in connection with a new issuance of bonds).  The notice states that a “State or local bond opinion is not subject to the requirements of section 10.35 [(of the final regulations)], but will be subject to proposed section 10.39 when it is finalized.” See the expanded definition below.  The expanded definition includes all opinions relating to the tax-exempt status of bonds (not just those rendered in connection with a new issuance of bonds).
  6. February 2006: IRS published proposed changes to Circular 230 with respect to contingent fees, conflicts of interest, standards with respect to tax returns, sanctions and certain other matters.  See 71 Fed. Reg. 6421.
  7. 2007: IRS announces settlement with bond lawyers in connection with an audited municipal bond issue for alleged violations of Circular 230. The settlement involved agreements by the attorneys to follow certain procedures in future bond transactions (including approval of opinions by the leader of the firm’s public finance group).
  8. September 2012: IRS publishes proposed regulations amending Circular 230, specifically removing the covered opinions requirements. (REG-138367-06)  These regulations would significantly modify the covered opinion and written opinion standards.  The proposed amendments do away will the concept in rule 10.35 of “covered opinions” entirely. Therefore, the proposed amendments from 2005 regarding municipal bond opinions become unnecessary.  Municipal bond opinions would be subject to a modified rule 10.37 (to which all other opinions would also be subject) that contain certain “basic principles” to which practitioners must adhere when providing written advice. Pursuant to these basic principles, the practitioner must “base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance and consider all relevant facts that the practitioner knows or should know.” These facts and assumptions would not need to be reflected in the actual opinion. The proposed amendments are quite extensive.  There is a statement to the effect that Treasury and the IRS believe that the amendments, if adopted, will make it unnecessary to include any disclaimers in written advice – those disclaimers only had the intended effect of avoiding an opinion to be considered a “covered opinion.
  9. June 2014: IRS publishes final regulations amending Circular 230, removing the covered opinions requirements, and therefore making Notice 2005-47 meaningless. (T.D. 9668)

Notice 2005-47:

Pursuant to Notice 2005-47, “State or local bond opinion” meant:  written advice (including electronic communications) that concerns —
  • (i) The excludability of interest on a State or local bond from gross income under section 103 of the Internal Revenue Code;
  • (ii) The status of a State or local bond as a qualified zone academy bond under section 1397E of the Internal Revenue Code;
  • (iii) One or more other Federal tax issues reasonably related and ancillary to advice described in paragraph (b)(9)(i) or (ii) of this section. Such issues include, but are not limited to—
    • (A) The application of section 55 of the Internal Revenue Code to a State or local bond;
    • (B) Whether a State or local bond has been reissued for Federal tax purposes;
    • (C) The status of a State or local bond as a qualified tax-exempt obligation under section 265(b)(3) of the Internal Revenue Code;
    • (D) The treatment of original issue discount or premium on a State or local bond under the Internal Revenue Code; and
    • (E) Whether the organization that is borrowing the proceeds of the State or local bond is described in section 501(c)(3) of the Internal Revenue Code; or
  • (iv) Any combination of the above.

Written Advice:

The final 2004 regulations state that written advice includes advice relating to an entity or any investment plan or arrangement a significant purpose of which is the avoidance or evasion of tax.  The principal purpose is not to avoid or evade tax if the entity, plan or arrangement has as its purpose the claiming of tax benefits consistent with the applicable statute and congressional purpose (e.g., Section 1603 Grants, ITCs, PTCs, NMTCs).

“Written advice” is “written advice” only if it is (a) a reliance opinion, (b) a marketed opinion, (c) subject to conditions of confidentiality, or (d) subject to contractual protection:

  • Marketed Opinion” is an opinion for which the practitioner knows or should know that it will be used in promoting, marketing or recommending an investment arrangement.  Marketed opinion status can be avoided, however, if the opinion is neither a listed transaction nor has a principal purpose to avoid or evade taxes, and if the opinion includes prominent disclosure that (i) it was not intended to be used, and cannot be used, to avoid penalties that may be imposed on the taxpayer, (ii) the advice was written to support the promotion or marketing of the transaction, and (iii) the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
  • Reliance Opinions” is [to come as needed]

Example Paragraph relating to Bonds:

Interest on the [Taxable] Bonds is not excludible from gross income of the owners thereof for federal and [State of XYZ] income tax purposes.  This opinion is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer under the Code.  We express no opinion herein regarding other federal, [State of XYZ] or local tax consequences arising with respect to the [Taxable] Bonds.