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

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.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: