Pooled Financing Bonds (I.R.C. 149(f)(4)(A))

February 25, 2013

General Discussion:

An issuer may decide to issue tax-exempt bonds for the purpose of making loans to two or more conduit borrowers.  Borrowers may be governmental entities, section 501(c)(3) organizations or private businesses.  Borrowers are generally interested in these types of financings because the pooling of proceeds may reduce issuance costs and lower interest rates.

Special tax rules may apply when bonds are issued to make loans to two or more conduit borrowers.  The rules result from the concern that tax-exempt bonds not be issued substantially in advance of when the proceeds are actually needed by the borrowers.  Other rules reflect the belief that pooled bond issuers should not unduly benefit from their issuance of the bonds on behalf of the ultimate consumers (the borrowers) of the proceeds.

There are special non-arbitrage limitations, arbitrage limitations, rebate rules and refunding rules for pooled financings.

Non-Arbitrage Limitations:

See I.R.C. 149(f), 149(g), 147(b)

Exceptions to Rebate:

There are certain special rules for pooled financings, including the rules described below.

With respect to the six-month spending exception to rebate, the six-month period for pooled financings begins on the issue date of the pool bonds (not on the date of the loan to the borrower).  Therefore, the gross proceeds are not treated as “spent” for purposes of the spending exception until the gross proceeds are spent for their ultimate purposes (rather than on the making of a loan).  Under Treas. Reg. § 1.148-7(b)(6), the pooled bond issuer may elect (on or before the issue date) to apply the spending requirements separately to each loan to a conduit borrower, as discussed in the next paragraph.  If the election is made and proceeds are loaned to the ultimate borrower, the six-month spending period begins for the loan on the earlier of (1) the date the loan is made or (2) the date 12 months from the issue date of the pooled bonds.

For purposes of the two-year construction spending exception to rebate, special rules provide that the Available Construction Proceeds (ACP) of pooled bonds that are construction issues automatically qualify for the two-year rule.  In other words, under I.R.C. § 148(c)(2), if pooled bonds are issued and part of the issue is used to make or finance loans for construction expenditures, that portion of the bonds is entitled to a two-year temporary period (two-year spending exception) rather than the six month spending exception.  The pooled bond issue may elect to apply the spending exceptions separately to each conduit loan.  If the election is made, then (1) the spending requirements for a loan begin on the earlier of the date the loan is made or the first day following the one-year period beginning on the issue date of the pooled financing issue, and (2) the rebate requirement (and none of the spending exceptions) applies to the gross proceeds on the issue before the date on which the spending requirements begin.  See Treas. Reg. 1.148-7(b)(6)(ii).  If the issuer makes this election, it may make all elections under the two-year rule separately for each loan, and may pay rebate with regard to some conduit loans and the 1.5% penalty for other conduit loans from the same pooled financing issue.  The 1.5% penalty is computed separately for each conduit loan.  If a borrower in the pool fails to meet the expenditure requirements, the issuer must pay rebate in accordance with the general rules of I.R.C. § 148(f)(2), unless it has elected to pay the 1.5% penalty in lieu of rebate.  This election must be made on or before the date the pooled bonds are issued and is irrevocable.  A pooled issue, however, may elect to terminate the 1.5% penalty for a loan rather than for the entire issue.

For purposes of the small issuer exception to rebate, in the context of a pooled financing in which the borrower otherwise meets the small issuer exception, the small issuer exception is available to the proceeds of the pooled issue in the hands of the small borrower.  The pooled financing may mix large and small issuers and treat each borrowing separately for purposes of available rebate exceptions.  A loan to a conduit borrower qualifies for the small issuer exception, however, only if (1) the bonds of the pooled financing are not PABs, (2) none of the loans to conduit borrowers are PABs and (3) the loan to the conduit borrower meets all requirements of the small issuer exception.  The issuer of the pooled financing issue is, however, subject to the rebate requirement for any unloaded gross proceeds.  Also, in determining the $5,000,000 size limitation of a pooled financing issuer, bonds of the pooled financing issue are not counted against the issuer for purposes of applying the small issuer exception to the issuer’s other issues, to the extent that the pooled financing issuer is not an ultimate borrower in the financing and the conduit borrowers are governmental units with general taxing powers and not subordinate to the issuer.  See I.R.C. 148(f)(4)(D)(ii)(II) and Treas. Reg. 1.148-8(d)(1).

Other Matters:

Private activity bond requirements:  I.R.C. § 147 – Maturity limitation

Other general bond requirements:  I.R.C. § 149

Current refundings versus advance refundings

PLR 200315012 regarding multipurpose issues and refundings

TEB enforcement of I.R.C. § 6700 penalties in pooled financing bond cases


Gannett and Jones, Pooled Financings, CPE Exempt Organizations Technical Instruction Program for FY 2000 Training.

Abusive Transactions and Anti-Abuse Rules under I.R.C. 149(d)(4) and Treas. Reg. 1.148-10

July 9, 2012


The Internal Revenue Service has stated that it will continue to invest significant resources in identifying abusive transactions in the municipal bond market in 2013.  What are some examples of abusive transactions?  What is a possible penalty for engaging in an abusive transaction?

General Discussion

I.R.C. § 149(d)(4) prescribes tax-exempt treatment of a bond if the bond is “issued to advance refund another bond and a device is employed in connection with the issuance of such [refunding] issue to obtain a material financial advantage (based on arbitrage) apart from savings attributable to lower interest rates.”

The Bond Attorneys Workshop outlines from 2010 explain that certain transactions are described as “devices” in the legislative history of I.R.C. § 149(d)(4) and in the General Explanation of the Tax Reform Act of 1986, at page 1215.  Treas. Reg. 1.148-10 of the 1993 Final Regulations also sets forth five additional examples of transactions that are considered abusive.  In Rev. Rul. 94-42, the IRS has indicated that another type of transaction may also cause the interest on bonds to be taxable.  Collectively, such sources indicate that the following are examples of abusive transactions:

  • Using refunding bond proceeds to pay debt service on the refunded bonds, which frees up revenues otherwise allocated to the payment of debt service, permitting the issuer to allocate the revenues to amounts used to pay a later installment of debt service. (Example 1 in the General Explanation)
  • Using (refunding) bond proceeds to pay costs which were to be paid with proceeds of the prior issue, and the proceeds of the prior issue are invested in an escrow established to pay debt service on the prior issue payable in future years.  The proceeds of the prior issue are invested at a materially higher yield that the yield on the bonds, or the issuer otherwise secured a material financial advantage from this replacement.  The IRS will treat the (refunding) bonds as advance refunding bonds for purposes of the additional restrictions on advance refundings, and the issuer is considered to have employed a device in connection with the issuance of the refunding bonds to obtain a material financial advantage apart from savings attributable to lower interest rates. (Example 2 in the General Explanation)
  • Receiving a direct monetary benefit with respect to the refunded bond by reason of issuance of an advance refunding bond, and the monetary benefit is not taken into account in determining the yield on the refunding bond.  For example, if an advance refunding bond enables the issuer to get back a portion of a premium on bond insurance paid on the prior issue (which would have been taken into account in calculating the yield on the prior issue) (or results in a reduction in the interest payable on the prior issue and thus a reduction in the amount of refunding bonds needed to refund the prior issue), the issuer will be considered to have employed a device in connection with the issuance of the refunding bond to obtain a material financial advantage apart from savings attributable to lower interest rates unless the yield on the refunding bond is determined by taking into account the direct monetary benefit (i.e., as an increase in the issue price of the refunding bond, which lowers the yield on the refunding bond). (Example 3 in the General Explanation)
  • Pursuant to a series of transactions, a prior issue is refunded by issuing (1) long-term advance refunding bonds (intended to be tax-exempt) to pay debt service on the prior issue in the early years, and (2) short-term advance refunding bonds (not intended to be tax-exempt) to pay debt service on the prior issue in the later years.  Proceeds of the short-term (taxable) advance refunding issue are invested at a yield materially higher than the yield on both the short-term and the long-term advance refunding issues, or the issuer otherwise secures a material financial advantage based on arbitrage by separating the two issues.  By separating the two issues, the issuer has attempted to exploit the difference between the taxable rate at which proceeds of the short-term advance refunding issue are invested and the tax-exempt rate of the long-term advance refunding issue.  If a material financial advantage has been obtained by separating the two issues, the issuer has employed a device in connection with the issuance of the long-term advance refunding bonds to obtain a material financial advantage apart from savings attributable to lower interest rates. (Example 4 in the General Explanation)
  • Bid rigging of investment and derivative contracts
  • Mispricing of bonds
  • The advance refunding bonds have “excess gross proceeds” (See Treas. Reg. § 1.148-10(c)(1) and also the heading below regarding excess issue price)
  • Crossover refundings unless they are described in the special rule for “excess gross proceeds” described in Treas. Reg. § 1.148-10(c)(4)
  • Gross refundings unless they are described in the special rule for “excess gross proceeds” described in Treas. Reg. § 1.148-10(c)(5)
  • Mortgage sale (See example 1 in Treas. Reg. § 1.148-10(d))
  • Bonds outstanding longer than necessary for yield-blending device (See example 2 in Treas. Reg. § 1.148-10(d))
  • Window refundings/debt service flip flops (See example 3 in Treas. Reg. § 1.148-10(d) and more details under the next heading)
  • Sale of conduit loan:  Conduit issuer sells the conduit note at a premium and deposits the proceeds to an escrow that is invested above the then-determined yield of the note. (See example 4 in Treas. Reg. § 1.148-10(d))
  • Re-refunding (See example 5 in Treas. Reg. § 1.148-10(d))

The examples above are only basic descriptions of the devices.  The cited examples should be referred to for full fact patterns and analyses.

Congress did not intend to prevent low-to-high advance refundings that occur (a) to obtain relief from specific covenants included in the refunded bonds or (b) to restructure debt service, so long as these advance refundings do not additionally involve a device.  See

The Internal Revenue Service may pursue actions under I.R.C. § 6700 against firms and individuals that violate tax laws by participating in abusive transactions.  Section 6700 provides for the imposition of penalties on “any person who […] (1) organizes (or assists in the organization of) a partnership or other entity, any investment plan or arrangement or any other plan or arrangement or participates (directly or indirectly) in the sale of any interest in an entity or plan or arrangement referred to above, and (2) makes or furnishes or causes another person to make or furnish (in connection with such organization or sale) (A) a statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement which the person knows or has reason to know is false or fraudulent as to any material matter, or (B) a gross valuation overstatement as to any material matter.”  The penalty imposed by I.R.C. § 6700 is in addition to any other penalty provided by law.  The burden of proof of whether or not a person is liable for the penalty in I.R.C. § 6700 is on the Secretary.

See the 2015 TAM below, which includes a discussion of abusive transactions.

Window Refundings

See Example 3 under Treas. Reg. 1.148-10(d) for a description of window refunding and the anti-abuse rule application.

An Authority issues its 1994 refunding issue to refund a portion of the principal and interest on its outstanding 1985 issue.  The 1994 refunding issue has zero-coupon bonds that pay no interest or principal for five years following issuance.  The proceeds of the 1994 bonds are deposited to a refunding escrow account to pay only the interest requirements on the 1985 bonds.

The Authority then enters into a GIC with a financial institution under which the institution provides a guaranteed yield on revenues invested by the Authority during the 5-year period.  The GIC has a yield that is not higher than the yield on the 1994 bonds.  The “revenues” invested by the Authority under the GIC consist of the amounts that the Authority otherwise would have used to pay principal of and interest on the 1994 bonds (presumably if the 1994 bonds had not been structured as zero-coupon no principal payment bonds).

The GIC is structured to generate receipts at times and in amounts sufficient to pay the principal and redemption requirements of the 1985 bonds.

A principal purpose of the 1994 bonds is to avoid transferred proceeds (any unspent 1985 proceeds).  (Transferred proceeds of the 1994 bonds would be such unspent 1985 proceeds when the 1985 bond principal amounts are paid with proceeds of the 1994 bonds.  The issuer would have to restrict yield on the transferred proceeds based on the yield of the 1994 bonds.  This would be disadvantageous if the 1994 bonds have a yield that is below the 1985 yield.)

The Authority will continue to invest the unspent proceeds of the 1985 issue that are on deposit in a refunding escrow for its 1982 issue at a yield equal to the yield on the 1985 issue and will not otherwise treat those unspent proceeds as transferred proceeds of the 1994 bonds.

The 1994 bonds are an issue of arbitrage bonds because those bonds involve a transaction or series of transactions that overburdens the market by leaving bonds outstanding longer than necessary to obtain a material financial advantage based on arbitrage.  Specifically, the Authority has structured the 1994 refunding issue to make available for the refunding of the 1985 issue replacement proceeds rather than proceeds so that the unspent proceeds of the 1985 issue will not become transferred proceeds of the 1994 refunding issue.

(The regular approach would have been to issue the 1994 bonds as normal amortizing bonds, use the proceeds of the 1994 bonds to pay principal and interest on the 1985 bonds, transfer unspent 1985 proceeds to the 1994 issue.  The unspent proceeds upon transfer would lose their eligibility to be invested at the higher 1985 yield.)

The same “flip-flop” window refundings were done with sinking fund GICs and bond funds.

TAM 201538013 (September 18, 2015): Summary: (1) There was no window refunding because, in part, there were other good reasons to structure the debt service schedule of the refunding bonds, (2) the remaining DSF moneys were not excess gross proceeds because they are “replacement proceeds in a sinking fund for the refunding issue” and (3) the transaction was not abusive because the issuer didn’t actually have any material financial advantage – it invested the “released revenues” below the refunding bond yield.

By how much may the issue price of a bond issue exceed the amount needed to finance the governmental purposes of the bonds?

This matter raises concerns relating to the abusive arbitrage devices analysis under Treas. Reg. § 1.148-10.  One type of abusive arbitrage device is a transaction that overburdens the tax-exempt bond market.  An overburdening in this sense occurs if the issuer issues more bonds than is otherwise reasonably necessary to accomplish the governmental purposes of the bonds, based on all facts and circumstances.  Certain factors are relevant in determining the overburdening status, including:

  1. Is the purpose of the transaction a bona fide governmental purpose (e.g., an issue of refunding bonds to achieve a debt service restructuring that would be issued independent of any arbitrage benefit)?
  2. Would the action be taken if the interest on the issue were not excludable from gross income under Section 103(a) of the Code?
  3. Does the issuance of the bonds exceed more than a minor portion of the amount necessary to accomplish the governmental purpose of the issue?
  4. Do the proceeds of the issue substantially exceed the amount of sale proceeds allocated to expenditures for the governmental purposes of the issue?
  5. Some of the aforementioned factors may be outweighed by other factors, however, such as bona fide cost overruns or long-term financial distress.
  6. There are special rules on excess gross proceeds of advance refunding issues that may give rise to abusive arbitrage device status.

“Minor portion” and “substantially exceed” are not defined under the abusive arbitrage device regulations.  Minor portion may be treated similarly to the general definition of “de minimis” in Treas. Reg. § 1.148-1(b), which generally means two percent of the stated redemption price at maturity.  Alternatively, one might look to the excess gross proceeds explanation for advance refunding bonds in Treas. Reg. § 1.148-10(c)(2), which states that such excess constitutes gross proceeds of an advance refunding issue that exceed one percent of the sale proceeds of the issue, other than certain gross proceeds allocable, e.g., to payment of debt service on the prior issue.  Some bond counsel have applied this one-percent standard before becoming concerned with possible overburdening issues.

Commingled Funds

February 7, 2012


Issuers of governmental bonds often commingle gross proceeds of an issue with other funds in order to provide for more efficient investment. The 1993 regulations provide special rules to prevent avoidance of rebate.  Nonetheless, commingling gross proceeds is not prohibited.

General Rules:

Commingled Fund

A commingled fund is defined as a fund or account that contains both the gross proceeds of an issue and amounts in excess of $25,000 that are not gross proceeds of that issue, if the amounts in the fund or account are invested and accounted for collectively, without regard to the source of funds. See Treas. Reg. 1.148-1(b).

Under Treas. Reg. 1.148-6(e)(1), an accounting method for gross proceeds of an issue in a commingled fund, other than a bona fide debt service fund, is reasonable only if it satisfies certain requirements set forth in the subsection and summarized below, in addition to the other requirements of the section:

  1. Investments held by a commingled fund: Generally, ratable allocations are required.  Not less frequently than as of the close of each fiscal period, all payments and receipts (including deemed payments and receipts) or investments held by a commingled fund must be allocated among the different investors in the fund. The allocation must be based on a consistently applied, reasonable ratable allocation method.  There are safe harbors for determining reasonable ratable allocations.
  2. Certain expenditures involving a commingled fund: […]
  3. Fiscal periods: […]
  4. Unrealized gains and losses on investments of a commingled fund: […] Note that the mark-to-market requirement does not apply to a commingled fund that operates exclusively as a reserve fund, sinking fund or replacement fund for two or more issues of the same issuer.
  5. Allocations of commingled funds serving as common reserve funds or sinking funds: See next heading.

Each different source of funds is an investor in the fund.  For example, a city that invests gross proceeds of a bond issue and receipts from taxes in a commingled fund is treated as two different investors.

The definition of commingled fund in Treas. Reg. 1.148-1 applies for purposes of Treas. Reg. 1.141-0 through 1.141-16.

There is a reference to a commingled fund concept in Treas. Reg. 1.141-1, which relates to a matter not related to this topic. (But, on a related matter, are there any private business use issues when reserve fund moneys from a reserve fund, originally funded with tax-exempt bond proceeds, are used to pay debt service on a taxable bond? Probably not if the reserve purpose is a neutral cost?)

There are reference to payments and receipts in connection with commingled funds in Treas. Reg. 1.148-3(d)(1)(i), (2)(i) and (3).

Exception for Commingled Funds Serving as Common Reserve Funds or Sinking Funds:

Notwithstanding the annual reasonable ratable allocation method required by paragraph (e)(2) of the regulations section, if a commingled fund serves as a common reserve fund, replacement fund or sinking fund for two or more issues (a commingled reserve), after making reasonable adjustments to account for proceeds allocated under paragraphs (b)(1) (the one-issue rule and general ordering rules)and (b)(2) (the universal cap on value of nonpurpose investments allocated to an issue rule), investments held by that commingled fund must be allocated ratably among the issues served by the commingled fund in accordance with one of the following methods:

  1. the relative values of the bonds of those issues under Treas. Reg. 1.148-4(e) (plain par bonds are valued at outstanding stated principal amount, plus accrued unpaid interest; other bonds are valued at their present value on that date);
  2. the relative amounts of the remaining maximum annual debt service requirements on the outstanding principal amounts of those issues; or
  3. the relative original stated principal amounts of the outstanding issues.

While exempt from the mark-to-market requirements described under the prior heading, investments in the reserve fund must still be valued at fair market value the first time they are allocated to proceeds. Treas. Reg. 1.148-5(d)(3).

An issuer must make any allocations required by this paragraph as of a date at least every 3 years and as of each date that an issue first becomes secured by the commingled reserve.  If relative original principal amounts are used to allocate, allocations must also be made on the retirement of any issue secured by the commingled reserve.

The exception for commingled reserve funds provides for the following test upon each new bond issue that is secured by the fund: (1) make sure not more than 10% of the sale proceeds of the new bonds are deposited to the reserve fund; (2) allocate the reserve fund and make sure that the portion allocable to the new bonds does not exceed the lesser of the three-prong reasonableness test for reserve funds.  The additional bonds test and definition of reserve requirement should reflect this test.

Refunding Question

Is the use of a parity reserve fund for the purposes of the fund a refunding of one issue with proceeds of another?  No.  In PLR 200441021, Congress’ intent is quoted as follows:

To rule that the use of a parity reserve under the specific conditions for which the reserve expressly was established is a refunding would place significant constraints on the function and utility of parity reserve funds, constraints that we do not believe Congress intended. In this case, however, Issuer’s proposed use of the amounts in the Reserve Fund is not under such conditions. Nevertheless, based on the facts and circumstances, we conclude that the proposed use is not a refunding.

Rulings Relating to Commingled Funds

PLR 200036033 (Jun. 7, 2000): Relates to Treas. Reg. 1.148-6(d)(6) – Expenditures of certain commingled investment proceeds of governmental issues.

FSA 001709 (Jan. 31, 2004):  Municipal bonds; litigation hazards; investment yield; management fee; safe harbors; arbitrage bonds.


Allocation and Accounting Regulations; What can be financed with tax-exempt bonds; Proceeds-Spent-Last; Working Capital; Hedge Bonds

July 1, 2011

General Matters

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:

  1. if they are allocated to an expenditure for a governmental purpose;
  2. 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;
  3. by retirement of the issue; or
  4. 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:

  1. Issuance costs or any qualified administrative costs;
  2. fees for qualified guarantees of the issue or payments for a qualified hedge for the issue;
  3. 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“);
  4. rebate amounts and other amounts paid to the United States;
  5. 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“);
  6. 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);
  7. 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.

Draw-Down Bond Matters

January 25, 2011

Issues Re: Draw-Down Loans:

A.  Information Reporting Requirements (1.149(e)-1(e)):

Generally, interest on a bond is included in gross income unless proper information reporting is accomplished with respect to the issue of which the bond is a part.  In a draw-down situation, the relevant question becomes: “what is the issue?”

Under (e)(2), the issue is defined, for information reporting purposes only (!), as bonds issued during the same calendar year. However, under (e)(2)(ii)(B), if the bonds issued pursuant to a draw-down loan meets the requirements of the first sentence of (B) (equally and ratably secured under a single indenture, etc.), bonds may be treated as the same issue even if issued during different calendar years, so long as all amounts to be advanced pursuant to the draw-down loan are reasonably expected to be advanced within three years of the date of issue of the first bond.

Note the special information reporting rules described in IRS Notice 2011-63 for bonds and draw-down loan bonds that have volume cap assigned to them.  The issue date for these bonds may be either the issue date of the bond or the issue date of the issue. If the election is made to use the issue date of the issue, the 8038 should include the phrase “FILED IN ACCORDANCE WITH NOTICE 2011-63 STATE AND LOCAL BONDS: VOLUME CAP AND TIMING OF ISSUING BONDS.”

B.  What is the “issue” and “issue date” of bonds issued pursuant to a draw-down loan?

Section 1.150-1(c)(4)(i) states that bonds issued pursuant to a draw-down loan are treated as part of a single issue.  The issue date of that issue is the first date on which the aggregate draws under the loan exceed the lesser of $50,000 or 5 percent of the issue price.  Notice 2010-81 clarifies that this is the approach to use to determine the issue date of bank qualified (QTEO) and 2% de minimis bonds.

C.  Are draws after 2010 on QTEO issued in 2009 or 2010 eligible for QTEO status ?

There has been discussion concerning what constitutes the issue date of bonds for determining BABs status or QTEO (bank qualification) status of draws made on such bonds after the ARRA provisions expired.  In Notice 2010-81, the IRS determined that, for purposes of determining whether a draw qualifies for BABs treatment, the applicable “issue date” is the date of the actual draw (i.e., the date of the bond resulting from the draw).  However, for purposes of determining whether such a draw qualifies for bank qualification under the ARRA rules, the IRS permits the issuer to use the issue date of the total issue (vs. issue date of the bond resulting from the draw). This means, if a draw-down loan and the related issue is properly issued in 2010, but a subsequent draw occurs in 2011, for purposes of determining that the draw falls within the ARRA QTEO rules, one looks to the issue date of the “issue,” and not the bond resulting from the draw.  See the McGuire Woods discussion of Notice 2010-81 linked here.

D.  In connection with a refunding/new money financing, may a draw-down for refunding establish the issue date, or does the draw-down need to be in respect of new money?

Some bond counsel have determined that the draw-down must be in respect of the new money portion.  A draw to cover the refunding is not sufficient. The 5 percent or $50,000 test is calculated using the full issue price, however (not the portion of the issue price allocable to the new money project).  Other bond counsel read the rule as permitting the initial draw with respect to the refunding without the need to draw on the new money portion as well.

E.  When you make the first draw, and also pay all costs of issuance, those COI may exceed 2% of the first draw. Is this a problem?

This topic was discussed at the 2011 TSLI in Austin, Texas. A March 11 NABL Weekly Wrap had the following to report concerning the matter: “The panel also focused on the requirements for filing Form 8038 when a bond is set up for draw-downs, as in a construction finance situation, and has a volume cap, and addressed the broad concern about Notice 2010-81, issued late last year. Panel Chair Linda Schakel, noted that in a construction situation, when the drawdown is in increments, the costs of the issuance would exceed two percent. Co-panelists John Cross of the IRS Office of Tax Policy, and Clifford Gannett, manager of the TEB Division at IRS, reassured the audience that the IRS and Treasury are working to clarify this before the filing season to avoid amended returns.”

While it may be safest not to permit more than 2% of each draw to be used for costs of issuance, facts and circumstances may suggest that increased percentages from initial draws are acceptable.    Factors to consider are whether a given draw will attempt to include the full 2% costs of issuance amount calculated based on the aggregate of all draws or whether the costs of issuance “overage” for a particular draw is small.  One might also include a covenant in the tax document requiring consultation with bond counsel in the event all expected draws do not occur to facilitate timely final allocation of bond proceeds away from costs of issuance.

F.  Issue date for QTEO draw-down bonds and Volume Cap: Conflicts in interpreting issue date?

From a recent IRS future guidance notice of December 2010: “Notice 2010-81 provided guidance regarding when State and local bonds are considered issued for purposes of various timing deadlines on issuing bonds. Issuers who entered into draw-down loans or commercial paper programs in 2010 before the release of Notice 2010-81 on November 23, 2010 or in earlier years and who acquired private activity bond volume cap under section 146 for the entire loan or program under the assumption that all of the bonds were issued in the year that draws under the loan or program exceeded $50,000 or larger, have expressed to the IRS and Treasury Department concerns that States have taken different approaches towards the treatment of such draws for volume cap purposes under section 146.  States and issuers have indicated that changing the different approaches to volume cap in this area presents administrative difficulties.  A complicating issue with respect to such volume cap awards is that the awards in 2008, 2009, and 2010 may include volume cap from the temporary $11 billion increase in annual private activity bond volume cap established under the Housing Assistance Tax Act of 2008 (See Notice 2008-79).  That temporary volume cap is not available after 2010.”

Relevant Private Letter Rulings and other Publications:

PLR 200147015: The issue date of a bond pursuant to a draw down is the date the interest actually begins accruing. The total project issue will not be issued earlier than necessary for purposes of 1.148-10(a)(4) (overburdening the tax-exempt market). In this letter ruling, the IRS approved the issue date determination and draw-down structure where funds were going to be drawn down over a five-year period.

Rev Rul 89-70 (1989) 1989-1 CB 88: Draw-down note is considered issued, for purposes of 26 USCS § 265(b), on date that more than de minimis amount is first advanced under note; amount of draw-down note is its stated principal amount.

IRS Form 8038 Matters

December 10, 2010


The issuer (or a person acting on behalf of the issuer) must make a good faith effort to complete the information reporting form (taking into account the instructions to the form).  The form must be completed on the basis of available information and reasonable expectations as of the date the issue is issued.  See section 1.149(e)-1(d)(1).

Filing Deadline:

IRS Form 8038 must be filed on or before the 15th day of the 2nd calendar month after the close of the calendar quarter in which the bond was issued.  A reference table showing filing deadlines is provided below.

Filing Deadline
Issue Quarter Filing Deadline
Quarter ending 12/31 2/15
Quarter ending 3/31 5/15
Quarter ending 6/30 8/15
Quarter ending 9/30 11/15

See Rev. Proc. 2002-48 for procedures regarding late filings of the information return.  See I.R.C. 7503 regarding filing information returns where the filing deadline is a Saturday, Sunday or legal holiday.

Number Conventions:

  1. You may round off to whole dollars.  Drop any amount less than 50 cents and increase any amount from 50 to 99 cents to the next higher dollar.
  2. Carry the yield out to four decimal places (for example, 5.3125%). Drop the decimals thereafter and do not round up.

Identification of the Reimbursement Amount (Starting in 2011):

In 2011, the IRS began requiring identification of the exact reimbursement amount of reimbursements from bond proceeds to the issuer in connection with the closing.  If the only reimbursement consists of preliminary expenditures, how should this new question be answered? One approach might be to state that no reimbursement is being made, because, for preliminary expenditures within the 20% limit, no official intent is required.  The better approach would likely be to include the amount of preliminary expenditures as the reimbursement amount, and then explain the reimbursement on an attachment to the IRS form.

Completing IRS Form 8038 For a Refinancing of Taxable Bank Indebtedness:

Issue: (1) Is the refinancing of taxable bank indebtedness considered a current or advance refunding of a “prior issue”? (2) Do you complete Part VI (of the June 2010 version of form 8038) for refinanced taxable bank indebtedness?

1.  What is a “prior issue” for purposes of lines 27 and 28? The instructions for line 27 and 28 require the insertion of the amount of bond proceeds used to pay principal, interest or call premium on any other “issue of bonds” within 90 days of the date of issue, or after 90 days of the date of issue, in the case of an advance refunding transaction. An entry in line 27 or 28 requires the completion of Part VI.

Generally, an “issue” is defined in section 1.150-1(c) as two or more “bonds” that meet certain requirements.  “Bond” is defined by section 1.150-1(b) as “any obligation of a State or political subdivision thereof under section 103(c)(1).”  This would lead to the conclusion that an issue, within the context of “prior issue,” must consist of obligations of a State or political subdivision. Therefore, obligations issued by a 501(c)(3) organization, for instance, would not be “bonds” within the meaning of the relevant tax provisions in title 26 of the Code.

“Prior issue” is directly defined in section 1.150-1(d)(5) as an “issue” of “obligations” all or a portion of the principal, interest or call premium on which is paid or provided for with proceeds of a refunding issue.  This definition is not helpful in that, while it refers to “issue” (which we now know is defined only as obligations of a State or political subdivision), it also refers to obligations, generally. “Obligation” is defined by section 1.150-1(b) as any valid evidence of indebtedness under general federal income tax principles.  Therefore, does “prior issue” include obligations issued by entities other than states or political subdivisions?

Frederic L. Ballard, Jr., in his book “ABCs of Arbitrage” explains that the “prior issue” does not have to be tax-exempt.  He points to a 1998 Technical Advice Memorandum in which the IRS explained that tax-exempt qualified 501(c)(3) bonds were a refunding issue if the proceeds were used by the 501(c)(3) borrower to redeem a taxable loan.  PLR/TAM 9831003.  See also section 1.148-6(d)(3)(ii)(A) and the attached The Bond Lawyer from 1998 referencing the TAM.

The TAM considers the tax-exempt bond refinancing by a 501(c)(3) University of a prior taxable loan.  The Service explains that, because the taxable loan constituted an “obligation” within the meaning of the regulations, the taxable loan therefore constituted a “prior issue” for purposes of section 1.150-1(d)(5).  As a result, the Service concluded that, because proceeds of the Bonds were used to redeem the taxable loan, the Bonds should be considered a “refunding issue.”

The TAM addresses the issue only with respect to whether or not the refunding bonds should be considered a “refunding issue” for purposes of the refunding rules.  The TAM does not address whether the taxable loan should also be considered a “prior issue” for purposes of lines 27 and 28 of the IRS Form 8038.

The best approach might be to complete Line 27 or 28 and add a footnote stating that: “The total amount in line 27 represents the current refunding of a prior taxable loan.  Pursuant to instructions to Form 8038, Part VI has been intentionally left blank.”  If the taxable loan was a bridge loan, one might instead treat that refinancing as a simple new money project.

2.  When is Part VI completed? Part VI should not be completed in connection with a refinancing of taxable indebtedness.  The instructions expressly state that Part VI should be completed only if the bonds are to be used to refund a prior issue of tax-exempt private activity bonds. “Tax-exempt bond” is any obligation on which the interest is excluded from gross income under section 103 of the code .  Taxable indebtedness is neither tax-exempt (see section 150(a)(6)) nor private activity bonds (see section 1.149(d)-1(g)(2)).

Checking the Box for Line 18:

Issue: When do you need to check the box for line 18 (Check box if 95% or more of net proceeds will be used only for capital expenditures)? If the bonds are part of a refunding issue, and the prior issue was a new money issue 95% of which financed a new money project, do you check the box?

Discussion: Bonds issued after August 5, 1997 for nonhospital expenditures, together with bonds issued prior to August 6, 1997, may not exceed $150 million in aggregate principal amount outstanding (Section 145(b)(1)). Bonds are issued for capital expenditures if 95% or more of the net proceeds are used solely for capital expenditures incurred after August 5, 1997.  It may be reasonable to state that the box should be checked if 95% or more of the net proceeds of the refunded bonds were used for capital expenditures and such refunded bonds were issued after August 5, 1997.

Note: A bond is a “qualified hospital bond” if it is issued as part of an issue 95% or more of the net proceeds of which are used with respect to a hospital.  If the bond is a qualified hospital bond, do not answer line 18. Instead, answer line 17.

Issue Date, and Draw Down Loans:

Note the special information reporting rules described in IRS Notice 2011-63 for bonds and draw-down loan bonds that have volume cap assigned to them. The issue date for these bonds may be either the issue date of the bond or the issue date of the issue. If the election is made to use the issue date of the issue, the 8038 should include the phrase “FILED IN ACCORDANCE WITH NOTICE 2011-63 STATE AND LOCAL BONDS: VOLUME CAP AND TIMING OF ISSUING BONDS.”  See also the draw-down loan posting on this site.

Calculating Yield:

Yield for capital appreciation bonds:

  1. A Capital Appreciation Convertible to Current Interest Bond might provide for capital appreciation (increasing principal) for the first three years to a “par amount,” and then interest and principal commencing at that point based on the “par amount.”
  2. You may consider calculating yield by treating the capital appreciation portion as “original issue discount,” and then discounting all cash flows based on the issue price at closing (the “unaccreted” value).
  3. Weighted average maturity is calculated by dividing bond years by the issue price. The usual bond year calculation won’t necessarily work with your spreadsheet because the deemed OID portion relating to the accretion is not reflected in the issue price of each principal payment. Therefore, to determine weighted average maturity (and bond years) for these types of CABs, determine what the accreted value as of the issue date is for each principal cash flow in later years. Do this by multiplying the number of bonds per principal payment (maturity) * the accreted value of each $5,000 par bond.  The number of bonds per principal payment (maturity) is calculated by dividing the principal payment on a particular date by the dollar value of each bond. E.g., if the payment is $40,000 on a particular date, and you have $5,000 bonds, that payment of $40,000 “implicates” 8 bonds.  Assuming the accreted value of each bond as of the issue date is $4,213, the total accreted value of the $40,000 is really only $33,708.  You then multiply this total accreted value by the years from the issue date to the principal payment date.  Do this for each principal payment and divide the aggregate sum by the issue price.

IRS Form 8038-T:

The Form 8038-T is used to pay (1) arbitrage rebate, (2) yield reduction payments (including payments relating to the transferred proceeds penalty), (3) the penalty in lieu of arbitrage, (4) the penalty to terminate the election to pay a penalty in lieu of arbitrage rebate, and (5) penalties and interest on the failure to pay on time any amounts in 1-4 above.

Refundings (Advance and Current)

October 19, 2010

General Rules:

A refunding issue means an issue of obligations the proceeds of which are used to pay principal, interest or redemption price on another issue, including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund or similar costs, if any, properly allocable to that refunding issue (Section 1.150-1(d) of the Regulations; See also 2009 BAW).

Current Refunding: When proceeds are used to retire or call other bonds within 90 days after the date of issuance of the refunding bonds.

Advance Refunding: When proceeds are used to retire or call other bonds more than 90 days after the date of issuance of the refunding bonds.  If the refunded bonds were issued before a certain date, 180 days applies instead of 90 days.  If any of the bonds of a refunded issue are called or retired more than 90 days (or 180 days, if applicable) after the date of issuance, the entire refunding becomes an advance refunding.

“Steps in the Shoes” Rule:

Under the “steps in the shoes” rule, the regulations treat the use of proceeds of the original bonds as the ultimate use of proceeds of any refunding bonds.  Treas. Reg. 1.103-7(d)(1), which memorializes this rule, states as follows:

In the case of an issue of obligations issued to refund the outstanding face amount of an issue of obligations, the proceeds of the refunding issue will be considered to be used for the purpose for which the proceeds of the issue to be refunded were used.  The rules of this subparagraph shall apply regardless of the date of issuance of the issue to be refunded and shall apply to refunding issues to be issued to refund prior refunding issues.

Advance Refunding Checklist:

This list identifies certain matters that must be reviewed prior to closing an “advance refunding” obligations issue.  The list will be updated periodically.

  1. SLGS:  SLGS (State and Local Government Series securities) must be ordered at least five to seven days [previously up to 15 days] prior to the closing.  (Note: If the issuer purchases open market Treasuries instead of SLGS in order to reduce the negative arbitrage that is inherent in SLGS, and if the Treasuries result in excess yield, the issuer must invest in other permitted investments, e.g., roll over into SLGS in order to blend the yields to an acceptable level permitted by the arbitrage rules.  However, when the SLGS window is closed, investment must be made in other permitted investments. The issuer must then make special yield reduction payments to the Treasury.  Not investing the money is not an option – the IRS imputes interest earnings on uninvested bond proceeds.)  Regulations concerning SLGS are found in Part 344 of Title 31 of the Code of Federal Regulations.  Once SLGS are subscribed, there is generally no opportunity to cancel or amend (with some exceptions) the subscription without incurring a six-month black-out penalty or certain penalty assessment fees.  The regulations do not describe a process for notifying the Bureau of Public Debt of a SLGS cancellation.  A written notice signed by the issuer specifying the Treasury Identification number and acknowledging the penalty may need to be faxed to the Bureau of Public Debt.  See Notiz 20130114 for details.
  2. First Call Date:  If the refunding of prior bonds may produce present value savings, the prior bonds must be called on the first call date (the “First Call Rule”). Section 149(d)(3)(A)(ii) and (B)(i).
  3. No Advance Refunding for Most PABs:  Private Activity Bonds may NOT be advance refunded unless they are qualified 501(c)(3) bonds. Section 149(d)(2).
  4. No Inheritance of Bank Qualification:  Bank qualification may be “inherited” under certain circumstances described in Section 265(b)(3)(C) and (D).  Such inheritance, however, is not permitted for advance refunding bonds.
  5. One Advance Refunding:  Bonds that may be advance refunded may generally be advance refunded only once. Section 149(d)(3)(A)(i). But note that an advance refunding issue that is not tax-exempt is not taken into account for that rule unless such advance refunding is pursued to avoid the limits of Section 149(d).  Section 1.149(d)-1(e)(1).
  6. Yield Restriction:  The yield on investment of proceeds of an advance refunding issue cannot be more than 0.001 percent above the yield on the refunding issue.  In other words, such proceeds are subject to the yield on the refunding issue, not the refunded issue.  If the refunding issue is a variable rate issue, one would generally use the lowest possible rate for the limitation.  If, however, the initial rate on the refunding issue is fixed for the period until discharge of the refunded bonds, that fixed rate can be the limitation.
  7. Unspent Proceeds:  Any unspent proceeds of the prior issue become “transferred proceeds” of the refunding issue when the prior issue is retired in the case of either an advance refunding or a current refunding.
  8. Excess Gross Proceeds:  Treas. Reg. 1.148-10(c) proscribes “excess gross proceeds” in connection with an advance refunding.  Existence of excess gross proceeds gives rise to an abusive arbitrage device and causes the refunding bonds to be arbitrage bonds, unless certain conditions in paragraph (2) of the regulations section are met.  Usually, bond counsel cover this aspect in the tax document by stating that all gross proceeds will be used in the manner described in the relevant section of the tax document.  Other bond counsel have proposed that the text of the regulation be summarized as a certification of the issuer. Notiz 20120125.  See also “Questions and Answers” below.
  9. Mixed Escrows:  There are several mixed escrow rules. See chapter 8B of Ballard, ABCs or Arbitrage.  Revenues contributed to a mixed escrow from a bona fide debt service fund for the prior issue must be “allocated to” – that is, treated as used to purchase – the earliest maturing investments in the mixed escrow (policy: funds originally held for a short-term purpose will continue to be used for essentially the same short-term purpose).  See the mixed escrow note below.

Types of Refundings:

  1. Net Refunding/Defeasance: This is the most common form of refunding.  Here, the original proceeds plus income from investments pays the interest on the prior bonds and their principal at maturity or on redemption.  Government obligations (usually treasuries) are bought in the open market (if they can be purchased at FMV at or below the bond yield) or SLGS, if available.
  2. Crossover Refunding:  Here, the income from investment of the refunding proceeds pays interest on the refunding bonds until a crossover date.  Before the crossover date, the debt service on the prior bonds is paid from the issuer’s revenues, and the debt service on the refunding bonds is payable from the income from investment of the refunding proceeds.  On the crossover date, the refunding proceeds pay the principal of the prior issue.  A crossover refunding might be beneficial if the investment yield permitted to the issuer is not available in the current market in any form of investment that would be eligible to defease the prior bonds in a net refunding (e.g., the escrow fund needs to be funded with money market funds, while outside of the escrow fund the refunding proceeds might be invested at a higher yield).  [This is a strategy to address contractual requirements – not to circumvent a federal tax requirement.]  Note that the crossover refunding structure is an exception to the excess gross proceeds restriction in Treas. Reg. 1.148-10(c)(5).  Excess gross proceeds may be used to pay interest that accrues on the refunding issue before the prior issue is discharged.  No gross proceeds of any refunding issue may be used to pay interest on the prior issue or to replace funds used directly or indirectly to pay such interest.
  3. Gross Refunding/Full Cash Defeasance:  Here, the refunding proceeds pay both principal and interest on the prior bonds without using investment income from the refunding proceeds, and the investment income pays debt service on a portion of the refunding bonds.  There is an excess gross proceeds issue with such gross refundings.  A gross defeasance is usually undertaken only if a defeasance of the refunded bonds is required and typically only if the prior bond resolution requires an initial deposit to the escrow of the full amount of the principal of and interest and call premium on the prior bonds, disregarding any interest that may be earned on the refunding escrow.  This method is not used frequently anymore because of complex investment and issuance rules that limit the benefits of such a transaction.  A full cash defeasance under post-November 1992 documents requires a ruling from the IRS.  (Note that this rule comes from Treas. Reg. 1.103-15(c), which was removed by the 1993 regulations.  So, if you don’t have bonds subject to these old regulations, this ruling requirement should not apply.)

Reasons to Refund:

  • To achieve debt service or interest cost savings: E.g., if rates in the market have dropped;
  • To restructure cash flow to obtain benefits;
  • To eliminate restrictive covenants in indentures or other documents: This may not be relevant for general obligation bonds which often don’t have any meaningful covenants.

Consequences of Not Being a Refunding:

If an issue is not considered a refunding (e.g., because of different obligors or certain acquisitions), it is a new money issue for federal income tax purposes.  Therefore, the issue must satisfy all applicable tax requirements to establish tax-exemption, such as requiring PAB volume cap, meeting rehabilitation requirements or subjecting the project and proceeds to more stringent requirements than may have applied with respect to the prior issue.
PLR 200230039:  State authority bonds won’t be treated as “refunding issue” of city bonds under Treas. Reg. § 1.150-1(d) where authority isn’t obligor of city bonds nor related party with respect to city bonds.

Transferred Proceeds:

In reviewing transferred proceeds matters for refundings, be sure to look for the possibility of cascading transferred proceeds, which are proceeds that transfer through several generations of refundings.  This can occur, for example, if refunded bonds effected a current refunding of a prior generation of refunding bonds, and the prior generation refunding bonds created an escrow for refunding purposes that still exists.  That escrow transfers all the way up to the refunding bonds and must be taken into account for yield restriction purposes.  In this example, the yield on the remaining escrow will have to be restricted to the yield on the refunding bonds as the proceeds transfer (as the refunding bonds pay the refunded bonds0.  That yield restriction is typically accomplished through the payment of a transferred proceeds penalty calculated at the time the bonds are priced or structured by the underwriter.  The main reason for a transferred proceeds penalty is because the escrow may be invested in SLGS that were originally structured to correspond to the escrow needs – and it may be impossible to change those SLGS to fit a lower yield restriction of the refunding bonds.  Notiz 20120429.
Transferred proceeds are calculated as described in Section 1.148-9(b).  “Principal amount” for purposes of the calculation is the stated principal amount for “plain par bonds” or the present value for bonds that are not “plain par bonds.”  One characteristic of a plain par bond is that it is issued with not more than a de minimis amount of original issue discount or premium.

Mixed Escrows:

See Treas. Reg. 1.148-9(c)(2).  When issuer revenues or unspent prior issue proceeds are included in an escrow fund, together with refunding bond proceeds, the technical rules for mixed escrow funds become applicable.  The mixed escrow rules are necessary because amounts from different sources have different tax attributes.  For example, proceeds of the refunding issue and issuer revenues have the following differing tax attributes:

  • Refunding issue proceeds are subject to yield restriction based on the yield of the refunding issue.  When these proceeds are used to pay debt service on the refunded issue, they will “trigger a transfer of any unspent proceeds of the prior issue.” (Ballard 171)
  • Prior issue proceeds are subject to yield restriction based on the yield of the prior issue, unless and until they transfer to the refunding issue, at which point they become subject to the yield of the refunding issue.
  • Revenues become replacement proceeds of the prior issue if the issuer contributes them to be used to pay off the prior issue, which means that these revenues are subject to yield restriction at the yield of the prior issue.

The issuer’s incentive is to keep proceeds subject to whatever provides the highest yield limitation.  For example, if remaining bond fund moneys (from the prior issue) are invested in investments with a yield that is higher than the refunding yield (plus spread) but below the prior issue yield limit, the issuer will want to make sure these bond fund investments remain allocated to the prior issue for as long as possible.  The issuer might therefore want to allocate these bond fund moneys to the very last maturities of the refunding.

The mixed escrow rules provide for the following requirements:

  • Revenues contributed to a mixed escrow from a bona fide debt service fund for the prior issue must be allocated to (treated as used to purchase) the earliest maturing investments in the mixed escrow.
  • Prior issue proceeds contributed to a mixed escrow from a project fund for the prior issue are subject to the same requirement of allocation to the earliest maturing investment.
  • Prior issue proceeds contributed to a mixed escrow from a reserve fund for the prior issue must be spent “ratably” with the refunding issue proceeds as to both sources and uses.
  • Revenues contributed to a mixed escrow fund from sources other than a bona fide debt service fund must be spent at least as fast as the refunding issue proceeds.

Advance Refunding Issues that Employ Abusive Devices:

An advance refunding escrow is an abusive device, if, among other things:
  1. Any of the proceeds of the advance refunding issue are invested in a refunding escrow in which a portion of the proceeds are invested in tax-exempt bonds and a portion in nonpurpose investments;
  2. The yield on the tax-exempt bonds exceeds the yield on the advance refunding issue;
  3. The yield on all investments (including the tax-exempt bonds and nonpurpose investments) in the refunding escrow exceeds the yield on the advance refunding issue; and
  4. The WAM of the tax-exempt bonds is more than 25% greater or less that the WAM of the nonpurpose investments in the refunding escrow, and the WAM of the nonpurpose investments in the refunding escrow is greater than 60 days.

See Treas. Reg. 1.149(d)-1(b)(3). [More to come]

Advance Refunding of a Taxable Obligation:

Treas. Reg. § 1.149(d)-1(e)(1) provides that the limitation on advance refundings set forth in I.R.C. § 149(d)(3)(A)(i) does not take into account an advance refunding of a taxable issue unless the taxable issue is a conduit loan of a tax-exempt conduit financing issue.  Note, however, that the refunding obligation still constitutes an advance refunding issue.  This regulation section simply exempts the issue from being considered in the advance refunding limitation rule.  For purposes of other rules, however, the “normal” advance refunding rules still apply.  Therefore, e.g., the materially higher definition of 0.001% applies to the escrow.

SLGS Matters:

April 29, 2013:  What will happen to SLGS subscriptions if the debt ceiling is not increased or the limit is not suspended by May 19, 2013?  Will SLGS subscriptions submitted to the Bureau of Public Debt prior to May 19, 2013 be honored or will the BPD cancel the subscriptions?  Under the suspension act signed into law by President Obama in February 2013 (No Budget, No Pay Act), the debt ceiling limit was suspended.  Once the suspension period ends, the debt limit existing on May 19 goes back into effect.  At that point, it appears the debt limit will have been exceeded.  Technically, the Treasury Department may take extraordinary measures to attempt to keep debt below the limit, similar to what was done in January 2013 when debt levels were nearing the ceiling.  It is unlikely, however, that enough measures can be taken to permit the BPD to continue SLGS issuances.  Further guidance from the Treasury Department is needed to understand what the likely approach will be.

SLGS and Rev. Proc. 95-47:

The SLGS program permits issuers to structure advance refunding escrows to achieve maximum efficiency within the yield limit.  Issuers may either (1) fully fund the refunding escrow with SLGS earning yields at a level permissible under the yield restriction rules or (2) combine SLGS with open market securities.  In the second scenario, the refunding escrow is typically  funded with open market securities (taxable Treasury securities) first because open market securities often provide a higher yield than the bond yield.  The escrow agreement will direct the escrow trustee at some point to roll over proceeds from sale of escrow securities into zero percent SLGS to blend down the overall yield of the escrow to avoid yield restriction problems.

See “The SLGS Compliance Initiative: A Correspondence Examination Initiative of Advance Refunding Bonds,” by Peter J. Mazarakos and Steven A. Chamberlin.

In November 1995, the Treasury Department provided guidance in Rev. Proc. 95-47 (1995-2 C.B. 417, 1995-47 I.R.B. 12) on how to address rollovers into zero percent SLGS during periods in which the sale of SLGS is suspended.  The Procedures states that an issuer may make special yield reduction payments (usually not permitted under Treas. Reg. § 1.148-5(c)(3)(ii) for advance refunding investments) if the following requirements are satisfied:

  1. The alternative investment (the investment purchased in lieu of the zero percent SLGS) is purchased on a date when the issuer is unable to purchase SLGS in lieu of the alternative investment because the Department of the Treasury has suspended sales of SLGS.
  2. The issuer reasonably expected on the issue date of the bonds that it would use bond proceeds to purchase SLGS on a date described in section 4.01(1) of the Procedure.
  3. The maturity date of the alternative investment is not more than 90 days from the date of purchase (trade date, not settlement date) of the alternative investment.
  4. The issuer exercises reasonable diligence to use the proceeds of the maturing alternative investment to purchase SLGS, if available, for the remainder of the term that was reasonably expected on the issue date.
  5. The payment to the United States is made not later than 180 days after the date of purchase of the alternative investment.
  6. The purchase price of the alternative investment does not exceed the fair market value of the alternative investment, and the issuer maintains books and records relating to the establishment of the purchase price.
  7. The payment to the United States is equal to the difference between the purchase price of the alternative investment on the date of purchase and the amount of all receipts from the alternative investment.

The special yield reduction payment is made in the same manner as normal yield reduction payments.  The following statement must be noted in the top margin of Form 8038-T: “Special Yield Reduction Payment Made Pursuant to Revenue Procedure 95-47.”

Query why the Treasury Department included a 90-day investment limitation.  Some bond counsel believe this period was chosen as a belt and suspenders limit – at that time, there had been no suspensions that had lasted longer than about 30 days.  The 90-day period was viewed as sufficient to cover all suspension periods.

Consider REG-106143-07, which would make Rev. Proc. 95-47 obsolete.   Making Rev. Proc. 95-47 probably means that the special 90-day holding limitation goes away.  Query whether the 180-day yield reduction payment requirement also goes away.  If the requirement goes away, the YRP will be due at the same time all other YRPs are due.  Some bond counsel believe that the 180-day requirement is eliminated along with the 90-day holding limitation.

If the escrow is rolled from one alternate investment to another alternate investment, how quickly does the second alternate investment need to be made after the first alternate investment matures?

Different Obligors:

Assume an issuer district (“District A”) issued Series 2002 Bonds to finance public improvements.  In 2013, another district (“District B”) will issue “refunding” bonds (the “Series 2013 Bonds”) to refinance the public improvements.  Assume also that prior to the refinancing District A has legal title to the improvements and after the refinancing District B will have legal title.  Will the Series 2013 Bonds be a refunding issue within the meaning of Treas. Reg. 1.150-1(d)(1)?

Treas. Reg. 1.150-1(d)(1) defines a “refunding issue” as an issue of obligations the proceeds of which are used to pay principal, interest or redemption price on a “prior issue,” including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, or similar costs, if any, properly allocable to that refunding issue.

Treas. Reg. 1.150-1(d)(5) defines a “prior issue” as an issue of “obligations” all or a portion of the principal, interest or call premium on which is paid or provided for with proceeds of a refunding issue.

A special rule in Treas. Reg. 1.150-1(d)(2)(ii)(A) provides that an issue is not a refunding issue if the “obligor” of one issue (e.g., the proposed Series 2013 Bonds) is neither the obligor of the other issue (e.g., the Series 2002 Bonds) nor a related party with respect to the obligor of the other issue.  Under Treas. Reg. 1.150-1(d)(2)(ii)(B), “obligor of an issue” means the actual issuer or, in conduit financings, the conduit borrower.

Assume District A and District B have the same members of the governing board.  Are District A and District B “related parties”?

Treas. Reg. 1.150-1(b) defines “related party” as any member of the same controlled group (if with respect to a governmental unit or a 501(c)(3) organization).  In Treas. Reg. 1.150-1(e), “controlled group” is defined as a group of entities controlled directly or indirectly by the same entity or group of entities.  Direct control is determined based on all facts and circumstances.  One entity or group of entities (the controlling entity) generally controls another entity or group of entities (the controlled entity) if the controlling entity possesses either of the following rights or powers and the rights or powers are discretionary and non-ministerial: (1) the right or power both to approve and to remove without cause a controlling portion of the governing body of the controlled entity; or (2) the right or power to require the use of funds or assets of the controlled entity for any purpose of the controlling entity.  (There is a special rule for indirect control, and there  is a special exception for general purpose governmental entities.)

Based on this definition and under the assumption described above, District A and District B would be related parties.  The Series 2013 Bonds would likely be a refunding issue.

(Some bond counsel, however, believe “control” – the right to approve or remove and the right to require use of funds or assets – must be more than merely momentary power due to board composition.  Instead, the power should be set forth in agreements between the two districts or in statutes.)

Assume, however, that District A and District B do not have any overlapping boards and are not part of the same controlled group.  In this case, the Series 2013 Bonds do not qualify as a refunding issue.  Instead, the Series 2013 Bonds are new money bonds, the proceeds of which are probably characterized as financing the acquisition of District A’s public improvements.

(But, query whether in a taxing district (District A)/issuing district (District B) where issuing district bonds are paid from taxes levied by the taxing district the true obligor isn’t District B from the start such that upon refunding there is no change in obligors.)

See AM2012-004, released 6/1/2012, in which the Office of Chief Counsel determines that there is no reissuance of tax-exempt or build America bonds where the State of California, by legislative act, dissolved all of its redevelopment agencies and vested all of their authority, rights, powers, duties and obligations in successor agencies.

Integrated Asset Acquisitions:

See PLR 201326007 and The Bond Buyer, IRS Rules Issuance of New Bonds is a Refunding, July 2, 2013.  Does a refunding followed by a sale of partnership interests in the conduit borrower cause the refunding bonds to be new money bonds (to which volume cap and other requirements may apply) or are the refunding bonds a “refunding issue” under Treas. Reg. 1.150-1?

“An issue is not a refunding issue if the obligor of the would-be refunding issue is not the obligor of the other issue.  Thus, if County X financed a water and sewage facility with tax-exempt bonds in 1994 and in 1998 sells it to unrelated County Y, which finances such purchase with a tax-exempt bond issue, the transaction will be treated as an acquisition of the facility and not as a refunding, even though County X used the proceeds from the sale to discharge its tax-exempt bond issue.” (From a Bond Attorneys’ Workshop outline)

Refunding of ARRA Bonds:

There is no statutory language on refundings for any of the disaster relief bonds or ARRA bonds, including the Recovery Zone Facility Bonds and Recovery Zone Economic Development Bonds and Build America Bonds.  There are “common law” principles that might support current refundings, but there has been no guidance, except to the extent described below.

For difficulties regarding legal defeasance of such bonds in advance refundings, see IRM and Treas. Reg. 1.1001-3(e)(5)(ii)(A) and (B).  The defeasance may be a reissuance of the defeased bonds.

A.  Gulf Opportunity Zone bonds (“GO Zone Bonds”); Midwestern Disaster Area Bonds; and Hurricane Ike Disaster Area Bonds

In Notice 2012-3 (2012-3 IRB 289) (January 17, 2012), the IRS permits the current refunding of GO Zone Bonds originally issued prior to the termination date of December 31, 2011, and the Midwestern Disaster Area Bonds and Hurricane Ike Disaster Area Bonds, issued under Sections 702(D)(1) and 704(a) of the Heartland Disaster Tax Relief Act of 2008, issued prior to the scheduled termination of December 31, 2012 (collectively, the “Disaster Area Bonds”).  The IRS supports its conclusion that current refundings of these bonds are permitted based on discussion by the Joint Committee on Taxation in “Technical Explanation of the Revenue Provisions of H.R. 4440, the ‘Gulf Opportunity Zone Act of 2005,’ as Passed by the House of Representatives and the Senate,” 5-6, JCX-88-05 (December 16, 2005).

Under the Notice, a current refunding is permitted after the termination date if the issue price of the current refunding issue is no greater than the outstanding principal amount of the refunded bonds. If the refunded bonds were issued with more than a de minimis amount of OID or OIP, the present value of the refunded bonds is used instead of the outstanding stated principal amount to determine the maximum issue price of the current refunding issue.

There is an express prohibition of advance refundings of GO Zone Bonds (See JCX explanation, page 6).

Notice 2012-3 specifically states that no inference may be drawn from the Notice that bonds issued to refund other types of bonds, such as Build America Bonds under I.R.C. 54AA, after their statutory deadline for issuance meet the qualifications for such types of bonds.  Therefore, the Service does not appear willing to extend the ability to currently refund bonds after the applicable termination date without express language similar to the statement in the JCX explanations.

See Notice 2010-10 for special reimbursement (official intent) rules relating to disaster area bonds.

B. Recovery Zone Facility Bonds (Exempt Facility Bonds)

See Notice 2014-09 for special current refunding guidance for Recovery Zone Facility Bonds.

C. Build America Bonds

See PLR 201149017 (December 2011), which concludes that the remarketing of BABs described in the ruling did not trigger a reissuance.

There is still no guidance or permission to refund Build America Bonds on either a current or an advance refunding basis with proceeds of a new Build America Bonds issue.

There is also no guidance on whether the IRS would continue to pay Build America Bonds subsidies during any escrow period if the Build America Bonds are current or advance refunded with proceeds of a new tax-exempt issue.

Questions and Answers:

  • Using refunding bond proceeds to pay the conduit issuer’s annual fee and a penalty fee: Payment of the annual fee is treated as interest, and the penalty fee (e.g., one year of annual fees) is simply a cost of completing the refunding. Both can be paid with proceeds of the refunding bond. Notiz 20111227.
  • What is a typical abusive transaction:  Fundamentals of Municipal Bond Law – 2007, on page 84, explains the issue as follows: “If an advance refunding issue is issued on a taxable basis, then such issue generally is not treated as an advance refunding issue for purposes of the Section 149(d) restriction on the number of advance refundings, unless such taxable issue is issued to avoid such limitation.  For example, if the taxable advance refunding issue is part of a series of refundings, is succeeded by a tax-exempt current refunding issue, and such tax-exempt current refunding issue and another tax-exempt issue in the series remain outstanding more than 90 days after the issuance of the tax-exempt current refunding issue, then the taxable advance refunding issue will be counted for purposes of the Section 149(d) restriction.”  In other words, if the first tax-exempt issue is advance refunded by the taxable loan, and within the escrow period a new tax-exempt current refunding refunds the taxable loan, the taxable advance refunding is counted as a “refunding” for purposes of Section 149(d).
    • See TAM 200424003:  Addresses the anti-abuse rules under Treas. Reg. 1.148-10 and the abusive transactions prohibition in Section 148(d)(4) of the Code relating to advance refundings.
  • Advance refunding of bonds originally issued in, e.g., 1983: Assume improvement bonds were issued in 1983, advance refunded in late 1986, current refunded in 1992 and current refunded in 2004.  May the 2004 bonds allocated to the 1983 bonds be advance refunded? Yes, because, under Section 149(d)(3)(A), the advance refunding in 2004 would be the “2nd” advance refunding of a bond that was issued before 1986.  See also Module C (“IRC Section 149”) of the Phase I IRS Tax Manual.
  • What to do with left over debt service funds of the prior issue: Consider the excess gross proceeds discussion in TAM 201538013.
  • How long may moneys be left uninvested:  Assume in a current refunding the issuer does not want to purchase investments because the purchase fee is too high, and instead wants to leave the moneys uninvested in the escrow fund until payment.  How long may the moneys be left uninvested?  If moneys are left uninvested too long, the IRS will impute interest.  Imputed interest could cause problems for the 2% costs of issuance limitation (if the imputed interest causes the 2% limit to be exceeded), or could be considered to be imputed working capital.  Some bond counsel prefer that moneys not be left uninvested for more than 15 days.  A 15-day period may be okay considering the need for moneys on monthly basis to pay interest.  Longer periods should be avoided.  See also the tax rules on abusive arbitrage devices including overissuance concerns.