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Proposed reliance regs except certain capital projects from arbitrage restrictions

June 12, 2018

IRS has issued proposed regs that would clarify the definition of “investment-type property” covered by the Code Sec. 148 arbitrage restrictions by expressly providing an exception for investments in capital projects that are used in furtherance of the public purposes of the bonds. The regs are proposed to apply to bonds sold on or after the date that is 90 days after publication as final, but may be applied by issuers to bonds sold before that date.

Background. In general, under Code Sec. 103, interest received by holders of eligible bonds issued by State and local governments is exempt from Federal income tax. As a result, tax-exempt State or local bonds generally have lower borrowing costs.

To qualify for the tax exemption, State or local bonds must satisfy various eligibility requirements, including the arbitrage investment restrictions under Code Sec. 148, which limit the investment of proceeds of tax-exempt bonds in higher yielding investments and require rebate to the Federal government of certain excess earnings on higher yielding investments.

Code Sec. 148(a) defines a taxable “arbitrage bond” as any bond issued as part of an issue any portion of the proceeds of which are reasonably expected to be used or are intentionally used to acquire “higher yielding investments” or to replace funds so used. “Higher yielding investments” mean any “investment property” that produces a yield over the term of the issue that is materially higher than the yield on the issue, and “investment property,” in turn includes any security (within the meaning of Code Sec. 165(g)(2)(A) or Code Sec. 165(g)(2)(B)), any obligation, any annuity contract, certain residential real property for family units located outside the jurisdiction of the issuer that is financed with bonds other than private activity bonds, and any “investment-type property.” (Code Sec. 148(b)(1)Code Sec. 148(b)(2))

In June of ’93, IRS issued comprehensive final regs on arbitrage investment restrictions, which have since been amended in certain limited respects.

Under current rules, Reg. § 1.148-1(e)(1) defines a catch-all category of “investment-type property” to include any property (other than securities, obligations, annuity contracts, and covered residential real property for family units under Code Sec. 148(b)(2)(A)Code Sec. 148(b)(2)(B)Code Sec. 148(b)(2)(C), and Code Sec. 148(b)(2)(E)) “that is held principally as a passive vehicle for the production of income.” For this purpose, Reg. § 1.148-1(e)(1) provides that the production of income includes any benefit based on the time value of money.

Clarification sought. Institutional investors have suggested that the above definition of “investment-type property” under Reg. § 1.148-1(e)(1) be clarified to ensure that the definition does not impede greater capital investment in public infrastructure.

Relevant legislative history supports limit.  The legislative history to the Tax Reform Act of 1986, P.L. 99-514, indicates that Congress intended to limit the scope of the arbitrage restriction on investment-type property so that it did not extend to investments in capital projects in furtherance of the public purposes of the bonds. Specifically, the House Report stated, with a substantially identical statement in the Senate Report, that:

The restriction would not apply, however, to real or tangible personal property acquired with bond proceeds for reasons other than investment (e.g., courthouse facilities financed with bond proceeds).

Proposed regs would add exception. To clarify the scope of the investment-type property definition consistent with the above Congressional intent, the proposed regs would provide an express exception to the definition of investment-type property for capital projects that further the public purposes for which the tax-exempt bonds were issued, e.g., a courthouse financed with governmental bonds or an eligible exempt facility under Code Sec. 142, such as a public road, financed with private activity bonds. (Prop Reg § 1.148-1(e)(4))

Applicability date. The proposed regs are proposed to apply to bonds sold on or after the date that is 90 days after the publication date of a Treasury Decision adopting these rules as final. (Prop Reg § 1.148-11(n)) However, IRS provided that issuers may apply the proposed regs to bonds that are sold before the applicability date provided in a Treasury Decision. (Preamble to Prop Reg REG-106977-18)

References: For arbitrage bonds, see FTC 2d/FIN ¶ J-3401 et seq.; United States Tax Reporter ¶ 1484 et seq.

Preamble to Prop Reg REG-106977-18Prop Reg § 1.148-1, Prop Reg § 1.148-11

IRS Notice of Proposed Rulemaking, “Arbitrage Investment Restrictions on Tax-Exempt Bonds” (6/11/2018)