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Timestamp: 2019-04-25 05:44:07+00:00

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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.
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).
Gannett and Jones, Pooled Financings, CPE Exempt Organizations Technical Instruction Program for FY 2000 Training.
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?
The examples above are only basic descriptions of the devices. The cited examples should be referred to for full fact patterns and analyses.
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.
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.
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 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?
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)?
Would the action be taken if the interest on the issue were not excludable from gross income under Section 103(a) of the Code?
Does the issuance of the bonds exceed more than a minor portion of the amount necessary to accomplish the governmental purpose of the issue?
Do the proceeds of the issue substantially exceed the amount of sale proceeds allocated to expenditures for the governmental purposes of the issue?
Some of the aforementioned factors may be outweighed by other factors, however, such as bona fide cost overruns or long-term financial distress.
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.
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.
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).
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.
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.
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 are reference to payments and receipts in connection with commingled funds in Treas. Reg. 1.148-3(d)(1)(i), (2)(i) and (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.
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.
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.
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.
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 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.
85 percent of the spendable proceeds of the issue must be spent for such purposes within the 5-year period beginning on such date.
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.
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.
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.
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.
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.
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.
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