Yield and Valuation of Investments (Treas. Reg. § 1.148-5)


The term “arbitrage bond” for purposes of I.R.C. § 148 means any bond issued as part of an issue any portion of the proceeds of which are reasonably expected (at the time of issuance of the bond) to be used directly or indirectly (1) to acquire higher yielding investments, or (2) to replace funds which were used directly or indirectly to acquire higher yielding investments.  For purposes of I.R.C. § 148(a), a bond is treated as an arbitrage bond if the issuer intentionally uses any portion of the proceeds of the issue of which such bond is a part in a manner described in (1) or (2).

“Higher yielding investment” means any investment property which produces yield over the term of the issue which is materially higher than the yield on the issue.

“Investment property” includes (A) any security, (B) any obligation, (C) any annuity contract, (D) any investment-type property, or (E) in some cases residential rental property.  Tax-exempt bonds do not generally include any tax-exempt bond.

Computation of arbitrage yield and rebate due on investments requires a valuation of the investments at various points in time. Investments must be appropriately valued upon purchase or sale and on any date that the investment becomes allocable to the issue or ceases to be allocable to the issue by virtue of the universal cap or the transferred proceeds rules. Also, in order to properly compute rebate due on any date other than a final computation date, an appropriate interim valuation must be made.  These rules are contained in Treas. Reg. 1.148-5.

PLR 9142012 (Jul. 17, 1991) (aka “Alabama” ruling): This letter is in response to your request on behalf of the Taxpayer for rulings that (i) the Authority’s proposed Bonds, the proceeds of which are to be used to make a payment under the Purchase Contract, will not by reason of that payment be private activity bonds within the meaning of section 141(a) of the Internal Revenue Code, and (ii) the Purchase Contract will not be investment property as defined in section 148(b)(2) .  The Authority argues that the up-front payment for capacity charges should be treated as an advance payment rather than as a private loan or other arrangement that would lead to “private business use” of the bond proceeds.  The IRS agrees.  The PLR then describes the history of the definition of “investments” and “investment-type” property.  Prepayments contain a time value of money component which gives them a built-in investment return.  Because of this, Congress recognized that prepayments may be investment property when they are made to avoid arbitrage restrictions instead of for other reasons.  The Authority had motivations to make the prepayment that were other than arbitrage avoidance.

Value of Investments:

The value of an investment on a date is determined using one of the following valuation methods consistently for all purposes of I.R.C. 148 to that investment on that date:

1. Plan par investment:  A plain par investment is valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date.

2. Fixed rate investment:  A fixed rate investment may be valued at its present value on that date.

3. Any investment:  Any investment may be valued at its fair market value on that date.

Any yield restricted investment must be valued at present value.  For example, a purpose investment or an investment allocable to gross proceeds in a refunding escrow after the expiration of the initial period must be valued at present value.

How do you value stocks or other types of equity that may be part of a reserve fund?  There is no guidance on how to value these types of investments.  Arguably, stock that doesn’t pay dividends doesn’t have an interest cash flow that might be viewed as a cash flow producing a yield.  How is appreciation of the stock captured in the calculation of yield?  One probably treats the appreciation on each valuation date as a cash flow giving rise to yield.  The valuation occurs on, among other dates, the date the investment becomes allocated to the issue, under Treas. Reg. 1.148-5(d)(3)(i), and on each rebate calculation date.  Many bond counsel advise clients not to transfer stock or other equity to a yield restricted fund because of the difficulty in valuing the stock and the lack of guidance.  Once concern is that significant appreciation could lead to endless excess arbitrage on the investment.

Investment-Type Property:

Investment-type property is defined as any property held principally as a passive vehicle for the production of income.  For this purpose, production of income includes any benefit based on the time value of money, including the benefit from making a prepayment.

The definition of investment-type property was revised in the final regulations published August 4, 2003 and effective October 3, 2003 (T.D. 9085).  The regulations provide rules for determining whether a prepayment for property or services results in a private loan or investment-type property.  See also the comments by NABL of December 23, 1999 regarding matters relating to the definition of investment-type property.

A prepayment in exchange for a simultaneous transfer of an ownership interest in property (tangible or intangible) is not a prepayment.

The primary purpose of adding the categories of annuity contract and “investment-type property” was to reverse the conclusion of several pre-1986 private letter rulings that held that annuity contracts and similar arrangements were not “securities or obligations” within the meaning of pre-1986 law.

Private loan context:  A loan may be either a purpose investment or a nonpurpose investment.  A loan that is a nonpurpose investment does not cause the private loan financing test to be met.  For example, proceeds invested in loans, such as obligations of the United States, during a temporary period, as part of a reasonably required reserve or replacement fund, as part of a refunding escrow, or as part of a minor portion are generally not treated as loans under the private loan financing test.  Treas. Reg. § 1.141-5(c)(2).

Treatment of RECs as investment-type property (capital asset concern, but also investment-type property concern)?  Building developers often purchase renewable energy certificates (RECs) to qualify for points under the LEED certification program.  The more points the building qualifies for, the higher the LEED rating.  To receive a LEED point by purchasing RECs, the RECs must document that the development/developer has entered into a contract of at least two years under which the development/developer is deemed to receive renewable energy.  RECs could be treated as capital assets that are capitalizable, and hence might be financeable with tax-exempt bond proceeds.  There is case law by the Tax Court (136 T.C. No. 15, April 2011) concerning the characterization of Colorado income tax credits.  (May the seller of Colorado income tax credits treat the gain as capital gain?)  The court concludes that the income tax credit is not specifically excluded from the definition of capital asset in I.R.C. 1221 (i.e., suggesting capital asset treatment) and that the income tax credit is not an income replacement (status of an item as an income replacement suggests that one should not allow the taxpayer to avoid ordinary income tax treatment by claiming the item as a capital asset).  Therefore, the income tax credit is a capital asset that, if sold, would lead to a capital gain or loss.  If the asset has a life of more than one year, it would be capitalizable.  This reasoning could apply to RECs such that RECs are capitalizable and therefore financeable with tax-exempt bonds.  The concern, however, is that RECs might be viewed as investment-type property because there is an active market for RECs.  One would need to make sure there is no plan to sell the RECs.  On the other hand, RECs give the holder the ability to achieve LEED certification, which may suggest that the RECs are a cost of the building – another basis for possible capitalization.

PLR 200116004 (Dec. 2000): Whether prepayment for water rights is investment-type property and a good reimbursement expenditure under Treas. Reg. 1.150-2.


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