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Parties Involved:
City of Columbus, Ohio
Appellant
Commissioner of Internal Revenue Service
Appellee

Document Text:

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United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued February 24, 1997 Decided May 13, 1997

No. 96-1282

CITY OF COLUMBUS, OHIO,

APPELLANT

v.

COMMISSIONER OF INTERNAL REVENUE SERVICE,

APPELLEE

Appeal from the United States Tax Court 

(3301-95B)

David L. Miller argued the cause for appellant. With him 

on the briefs was David A. Rogers.

Kenneth W. Rosenberg, Attorney, U.S. Department of Justice, argued the cause for appellee. With him on the brief 

was Loretta C. Argrett, Assistant Attorney General, and 

Richard Farber, Attorney. Gary R. Allen, Attorney, entered 

an appearance.

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Before: EDWARDS, Chief Judge, SENTELLE and RANDOLPH, 

Circuit Judges.

Opinion for the Court filed by Circuit Judge RANDOLPH.

RANDOLPH, Circuit Judge: The City of Columbus, Ohio, 

issued short-term Bond Anticipation Notes to satisfy a financial obligation to the State of Ohio. Columbus intends to 

issue long-term bonds to refinance the currently outstanding 

Notes. The ultimate question in this appeal from the Tax 

Court is whether the city's proposed bonds would be "arbitrage bonds" within the meaning of § 148 of the Internal 

Revenue Code of 1986, as amended, a question of significance 

to the parties because interest on municipal bonds is exempt 

from taxation under § 103(a) of the 1986 Code, while interest 

on arbitrage bonds is not.

I

Columbus had been administering two unfunded pension 

funds for its police officers and firefighters. Then, in the 

mid-1960's, the State of Ohio created the Police and Firemen's Disability and Pension Fund, a statewide pension fund 

replacing the unfunded plans of municipalities with a fullyfunded pension plan for police officers and firefighters. This 

State Fund assumed the pre-1967 pension liabilities of Ohio 

municipalities. State law required each municipality to transfer its liabilities and assets to the State Fund and then pay 

the State Fund the present value of the municipality's accrued unfunded pension liability. Columbus's bill came to 

$42,687,799. Municipalities had the option of satisfying their 

obligations to the State Fund immediately or over a period of 

time, with interest. Columbus chose the latter course and 

began making annual payments to the State Fund. After 

several changes in state law, the city wound up with a 

payment schedule imposing annual interest charges of 4.25% 

until the year 2035.

In 1993, Ohio offered municipalities the opportunity to prepay at a discount their obligation to the State Fund in a 

single, lump-sum payment. See OHIO REV. CODE ANN. 

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The Notes have been issued to investors without any opinion 

regarding their tax-exempt status and have borne a taxable interest 

rate. See Brief for Appellant at 5 n.2. 

§ 742.30(C) (Anderson Supp. 1995). The State Fund adopted 

a discount of 35%, allowing municipalities to satisfy their 

obligations by paying 65% of their outstanding principal 

balance. Thirty-six Ohio municipalities, including Columbus, 

accepted the offer. This reduced Columbus's obligation from 

$41,435,720 to $26,933,218. On January 31, 1994, Columbus 

paid the State Fund $27,304,720, an amount representing the 

city's discounted outstanding principal balance plus $371,502 

in interest.

Columbus had contemplated financing this 1994 payment 

by issuing tax-exempt bonds, and asked the IRS for a ruling 

that the interest on its bonds would qualify for tax exemption 

under § 103 of the 1986 Code. In the meantime, Columbus 

had issued $27,300,000 in one-year Bond Anticipation Notes in 

January 1994. The Notes' proceeds were transferred to the 

State Fund to satisfy the lump-sum agreement. When (for 

reasons described next) the Assistant Chief Counsel of the 

Treasury issued a private letter ruling against the city, 

Columbus once again issued one-year Notes in 1995 to pay off 

the 1994 Notes. These Notes were set to mature on January 

30, 1996. All the proceeds of the 1995 Notes were used to 

pay off the 1994 Notes. Columbus intends to continue in this 

manner, refinancing outstanding Notes with subsequent 

short-term issues, until there is a final judicial determination 

regarding the tax status of its proposed bonds.1 At that time, 

Columbus's plan is to issue long-term bonds either on a taxexempt or taxable basis, and immediately use the bonds' 

proceeds to pay off outstanding Notes and associated expenses.

Columbus submitted its ruling request to the Internal 

Revenue Service seeking a determination that the assumed 

6% interest, compounded semiannually, on its proposed longterm bonds would be excludable from the bondholders' gross 

income under § 103 of the 1986 Code. The private letter 

ruling against Columbusthat the proposed bonds would be 

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arbitrage bonds and hence the interest on them would be 

included in the bondholders' gross incomerested mainly on 

a theory not raised in this appeal. The Assistant Chief 

Counsel noticed that the State Fund was earning 8.25% 

compounded annually on the money in the pension fund. 

Priv. Ltr. Rul. 95-09-035 (Mar. 3, 1995). On the other hand, 

the city's proposed bonds would yield 6%. The ruling stated 

that "the State Fund expected to be able to invest the amount 

of the prepayment of the City Liability at a yield that is 

materially higher than the yield on the issue of Proposed 

Bonds." Id. This constituted "arbitrage." No matter that 

two separate entities were involved, with one (the city) issuing the bonds and paying the "yield" on them, with the other 

(the State Fund) investing the proceeds and receiving the 

"yield" on those investments. There was, according to the 

ruling, no requirement "that investments must be owned or 

directly controlled by an issuer to be treated as proceeds of 

an issue." Id.

Columbus filed a petition in the Tax Court seeking a 

declaratory judgment that the interest on the proposed bonds 

would be tax-exempt. The Tax Court held that the proposed 

bonds would be "arbitrage" bonds within the meaning of 

§ 148(a) of the 1986 Code. Without mentioning the theory of 

the private letter ruling, the court reasoned that Columbus's 

prepayment of its obligation to the State Fund at a discount 

produced the equivalent of a 7.57484% "yield" on its "investment," a materially higher "yield" than the 6% it would be 

paying on the proposed bonds. The 7.57484% figure represented the per annum rate at which the city would have had 

to invest the amount of its lump-sum payment to have received a stream of income equal to the installment payments 

it would otherwise have made to the State Fund. We will 

have more to say about the Tax Court's rationale in a 

moment.

II

Why the special rules about "arbitrage" bonds? The Internal Revenue Code had, for many years, excluded from gross 

income the interest taxpayers receive on state or local bonds. 

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This enabled states and municipalities to issue tax-exempt 

bonds at interest rates favorable to them. These governmental entities also could, through so-called "arbitrage," reap 

returns at the expense of the federal treasury. A municipality could, for instance, issue tax-exempt bonds at 6% and then 

invest the proceeds in taxable securities yielding, say, 10%. 

1 B. BITTKER & L. LOKKEN, FEDERAL TAXATION OF INCOME,

ESTATES, AND GIFTS ¶ 15.5.1 (2d ed. 1989). The arbitrage bond 

provisions of the 1986 Internal Revenue Code, like their 

counterparts in the Tax Reform Act of 1969, Pub. L. No. 

91-172, 83 Stat. 656, were designed to put a stop to this 

practice. See State of Washington v. Commissioner, 692 

F.2d 128, 134 (D.C. Cir. 1982).

While interest on state or local bonds remains generally 

exempt from federal taxation, § 103(b) of the 1986 Code 

renders the exemption inapplicable to any "arbitrage bond" 

within the meaning of § 148. An "arbitrage bond," as 

§ 148(a) defines it, is

any bond issued as part of an issue any portion of the 

proceeds of which are reasonably expected (at the time of 

issuance of the bond) to be used indirectly or directly

(1) to acquire higher yielding investments, or

(2) to replace funds which were used directly or indirectly to acquire higher yielding investments.

A "higher yielding investment" is, according to § 148(b)(1), 

"any investment property which produces a yield over the 

term of the issue which is materially higher than the yield 

on the issue." "Investment property" is defined in 

§ 148(b)(2)(D) to include "any investment-type property."

Through a critical, but unchallenged Treasury regulation, 

"investment-type property" includes "a prepayment for property or services ... if a principal purpose for prepaying is to 

receive an investment return from the time the prepayment is 

made until the time payment otherwise would be made." 

Treas. Reg. § 1.148-1(b). The rulemaking notice proposing 

the prepayment regulation tells us almost nothing of its 

origins or of the problems it was meant to solve. 57 Fed. 

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Reg. 53,046, 53,047 (1992). The private letter ruling in this 

case offered this brief explanation: "Prepayments contain a 

time value of money component, giving them a built-in investment return." Priv. Ltr. Rul. 95-09-035 (Mar. 3, 1995). As 

applied to the city and its prepayment, the explanation makes 

no sense. A prepayment can contain a time value of money 

component for the payee, but here the payee was the State 

Fund. As to payees or recipients of prepayments, the value 

to them lies in the adage: "A bird in the hand is worth two in 

the bush." In financial terms, cash today is worth more than 

cash in the future and investors would rather have the cash 

now so that they can increase its value over time. (Of course, 

other factors such as inflation and risk can decrease the value 

of money in the future.) See Motion Picture Ass'n of America, Inc. v. Oman, 969 F.2d 1154, 1157 (D.C. Cir. 1992); 

Daniel I. Halperin, Interest in Disguise: Taxing the "Time 

Value of Money," 95 YALE L.J. 506 (1986). Thus, the private 

letter ruling's observations about the time value of money and 

the purpose of the prepayment regulation are pertinent to the 

State Fund, but not to Columbus. The financial benefit to 

the city stemmed from the discount the State Fund gave it 

for paying its debt early.

At any rate, the IRS's theory on appeal is that by paying 

off its debt to the State Fund in 1994, Columbus acquired 

"investment-type property" within the meaning of this prepayment regulation (Treas. Reg. § 1.148-1(b)). The city's 

proposed bonds would be traced back to that 1994 transaction 

since the proceeds of those bonds would be used to pay off 

the city's short-term notes. One of the city's principal purposes for the 1994 transaction was to "receive an investment 

return"namely, the difference between the 7.57484% "yield" 

resulting from the 35% discount the state offered, and the 

assumed "yield" of 6% on the city's proposed bonds. The 

city's 1994 satisfaction of its obligation to the state was, the 

IRS tells us, a "higher yielding investment," that is, an 

"investment property which produces a yield over the term of 

the issue which is materially higher than the yield on 

the issue." § 148(b)(1). (A spread of more than 1/8th of a percent is a "materially higher yield" under Treas. Reg. 

§ 1.148-2(d)(2).)

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In the Tax Court, the city disputed this particular IRS 

theory on the basis that one cannot acquire "property" by 

satisfying one's own debt, which is how the city viewed the 

1994 transaction and, hence, the consequences of its proposed 

bonds. The Tax Court acknowledged the city's argument but 

said it did not have to pass on it because the IRS's position 

could be supported on another ground: "The City Obligation 

represented the payment for the obligation of the State Fund 

in 1967 and we think that nexus remained extant at the time 

of the 1994 prepayment. In short, the source to which the 

prepayment applied was the acquisition of the obligation of 

the State Fund and controls the character of the transaction." 

Therefore, the court concluded, "the prepayment was for 

property and consequently we turn to the question whether it 

[the prepayment] was "investment property.' "

The Tax Court's reasoning appears to be that Columbus 

acquired "property" in 1967 when the state took over the 

city's pension fund for police officers and firefighters. (We 

suppose the court thought this was the same as if the city 

gone out and purchased an annuity, although the city did not 

voluntarily engage in the 1967 transaction.) And, the court 

held, the city acquired "property" againthis time "investment-type property" within Treas. Reg. § 1.148-1(b)when 

it paid off its debt to the state in 1994. We shall assume the 

Tax Court is correct in viewing the 1967 transaction as one in 

which the city acquired "property." Even so, we cannot 

understand how the 1994 transaction constituted a "prepayment" for that 1967 "property." One would think "prepayment" signifies paying for property before receiving it. But 

the situation here is just the opposite. First the city received 

the property and then it began paying for it over time. 

Suppose, in 1967, the city had taken out a 20 year loan from a 

bank for the $42,687,799 and immediately turned the money 

over to the State Fund. If the city paid the bank ahead of 

time, no one would suppose the city thereby prepaid for its 

1967 property. The city would be prepaying something 

elseits debt to the bank. We cannot see how this would 

constitute a "prepayment for property" unless settling one's 

debt before it falls due is acquiring property, the very question the Tax Court said it would not resolve.

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In order to be arbitrage bonds, the proceeds of the city's 

proposed bonds must also be used to acquire "higher yielding 

investments." § 148(a). This calls for a comparison. Treas. Reg. 

§ 1.148-2 instructs one to compare "the YIELD on investments" 

with "the YIELD on the ISSUE to which the investments are 

allocated...." This is easy enough if a municipality purchases 

mortgage-backed securities yielding 8% (the "investments") by using the proceeds of bonds yielding 6% (the "issue"). Here the 

"investment," according to the IRS, is the city's prepayment of its 

obligation to the state. We understand why this "investment" gives 

rise to a savings, but it is scarcely clear how prepaying an obligation 

gives rise to a "yield." Fifteen years ago we thought "yield" had "a 

common and accepted meaning: it is the economic return on a debt 

instrument." State of Washington, 692 F.2d at 131. Matters may 

now have changed with the promulgation of Treas. Reg. § 1.148-5. 

We need not say more on the subject, however, because the city has 

not pressed the point. 

The private letter ruling ducked the issue in this way:

if the concept of a prepayment is limited ... to certain 

payments for property or services, then an issuer could avoid 

the arbitrage restrictions by, for example, contracting for the 

purchase of any item (e.g., property or services), agreeing to 

pay over time and then paying early to retire the debt.

Priv. Ltr. Rul. 95-09-035 (Mar. 3, 1995). Translation: the IRS 

may ignore the words of the Treasury's regulation"prepayment 

for property or services"if the words produce a result the IRS 

does not want. 

The IRS's theory on appeal has the same reasoning gap. 

Of course the IRS is right that the 1994 transaction was 

financially beneficial to Columbus. And we may assume the 

IRS is also correct that maximizing that benefit by issuing 

tax-exempt bonds was "a principal purpose" of the city. See 

Santa Fe Pacific Corp. v. Central States Pension Fund, 22 

F.3d 725, 727 (7th Cir. 1994). We also have no doubt that the 

1994 transaction was a "prepayment." But was the city's 

prepayment "for property"? Only if it was may the prepayment itself be treated as "investment-type property" under 

the regulation.2 And so we are back to the same unanswered 

questiondid the city, by retiring its debt to the state, 

prepay for "property"? What "property" could that be other 

than the city's obligation to the state? At argument, counsel 

for the IRS stated that the "acquisition" of one's indebtedness 

constitutes the acquisition of one's "property," but counsel 

failed to provide any support for this unusual view of the 

meaning of "property." The IRS's brief does not address the 

proposition.3

We will put this question aside. Still we must examine the 

consequences of treating the city's lump-sum payment in 

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1994, not as a "prepayment," but as the city's payment in full 

for the "property" it acquired in 1967. If the Tax Court is 

correct that the source to which the payment applies

acquisition of "property" in 1967"controls the character of 

the transaction" in 1994, then the city's proposed bonds 

cannot be treated as arbitrage bonds. For one thing, the IRS 

has not contended that the city's 1967 property was of the 

"investment-type" under § 148(b) of the 1986 Code. For 

another thing, the relevant portion of § 148 of the 1986 Code 

could not be applied retroactively to the 1967 transaction. 

That transaction took place two years before the Code contained provisions barring tax-exempt status for interest on 

arbitrage bonds. See 1 BITTKER & LOKKEN, supra, ¶ 15.5.1. 

When Congress dealt with the subject in 1969, the provisions 

it added to the 1954 Code defined arbitrage bonds to mean 

any bond the proceeds of which are used to acquire "securities" or "obligations." See State of Washington v. Commissioner, 692 F.2d at 130. The 1986 Code replaced the quoted 

terms with "higher yielding investments," defined in § 148 to 

include "any investment-type property." A retroactivity rule 

was therefore needed. Rather than leave this to the IRS and 

the courts, Congress enacted § 1314(h) in the Technical and 

Miscellaneous Revenue Act of 1988:

In the case of a bond issued before August 16, 1986 

(September 1, 1986 in the case of a bond described in 

section 1312(c)(2)), section 103(c) of the 1954 Code shall 

be applied by treating the reference to securities 

in paragraph (2) thereof as including a reference to 

investment-type property but only for purposes of determining whether any bond issued after October 16, 1987, 

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Section 149(d)(5) provides that "a bond shall be treated as 

issued to advance refund another bond if it is issued more than 90 

days before the redemption of the refunded bond." The distinction 

between a current refund bond and an advance refund bond is that 

a current refund bond is one that refunds a prior bond within 90 

days of its issuance. See Treas. Reg. § 1.150-1(d)(3) & (4). The 

city's 1994 short-term notes and each refinancing of them, including 

the proposed bonds, are "current refundings" and not "advance 

refundings," because the city did not (and will not) hold the 

proceeds for more than 90 days before using them to retire the 

earlier obligations. 

to advance refund such bond (or a bond which is part of a 

series of refundings of such bond) is an arbitrage bond 

(within the meaning of section 148(a) of the 1986 Code).

Pub. L. No. 100-647, § 1013(d)(3), 102 Stat. 3342, 3548.

The city claims that for purposes of § 1314(h), the relevant 

"bond issued before August 16, 1986" is its obligation 

to the State Fund incurred in 1967. "State or local bond" is 

defined in § 103(c)(1) of the 1986 Code as "an obligation of a 

State or political subdivision thereof." See also Treas. Reg. 

§ 1.150-1(b). Columbus's 1967 debt to Ohio seems to fit the 

bill. The IRS has chosen not to oppose the city's position on 

this subject, which is supported by other authority. See JOINT 

COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX 

REFORM ACT OF 1986, at 1156 n.43 (1987) ("Under these rules, 

as under prior law, the term bond also includes debt obligations of a qualified governmental unit that do not involve 

the formal issuance of a bond or note."). The city's proposed 

bonds will "currently refund" the obligation in 1967.4 The 

1994 short-term notes could not serve to break this link. 

The "Transferred Proceeds Allocation Rule," Treas. Reg. 

§ 1.148-9(b)(1), provides that when the "proceeds of the 

refunding issue discharge any of the outstanding principal 

amount of the prior issue, proceeds of the prior issue become 

transferred proceeds of the refunding issue and cease to be 

proceeds of the prior issue." "Refunding issue" is defined as 

"an issue of obligations the proceeds of which are used to pay 

principal, interest, or redemption price on another issue...." 

Treas. Reg. § 1.150-1(d). Here, the proceeds of the proUSCA Case #96-1282 Document #271680 Filed: 05/13/1997 Page 11 of 12
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posed bonds would be used to discharge the outstanding 

notes. The proposed bonds would thus be a refunding issue 

of the notes. The proceeds of the notes are allocated to the 

1967 obligation, which they refunded. So the proposed bonds 

would currently refund the obligation. Under § 1314(h), the 

proposed bonds would therefore be a current refund of a preAugust 16, 1986, bond, to which the concept of "investmenttype property" does not apply.

The IRS asks us to sustain the Tax Court's decision on an 

alternative ground not dependent on whether the city, in 

1994, acquired investment-type property by prepaying its 

obligation to the state. The argument is that Treas. Reg. 

§ 1.148-10(e), the "anti-abuse" regulation, permits the Commissioner "to depart from the technical provisions of the 

regulations to achieve a result in keeping with the economic 

substance of the transaction." Brief for Appellee at 31. But 

the anti-abuse regulation does not go so far. It conditions the 

Commissioner's exercise of this authority on the issuer's 

entering into a transaction to obtain "a material financial 

advantage based on the difference between tax-exempt and 

taxable interest in a manner that is inconsistent with the 

purposes of section 148." Since we believe the Tax Court 

erred in treating the 1994 transaction as a prepayment for 

property the city acquired in 1967, and since this doubtless 

colored the court's view of what was, or was not inconsistent 

with the purposes of § 148, we cannot affirm the decision on 

the basis of the anti-abuse regulation. The purpose of § 148 

is to prevent states and local governments from using taxexempt bond proceeds to acquire higher yielding "investment 

property." Even if a "prepayment for property" may itself 

be investment property, it remains to be seen whether the 

City of Columbus, by satisfying its obligation to the State 

Fund in 1994, was making a "prepayment for property." 

Before the anti-abuse regulation is considered, that question 

must be resolved.

The judgment of the Tax Court is vacated and the case is 

remanded for further proceedings consistent with this opinion.

Vacated and remanded.

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