Source: https://www.federalregister.gov/articles/2007/09/26/07-4734/arbitrage-guidance-for-tax-exempt-bonds
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Federal Register | Arbitrage Guidance for Tax-Exempt Bonds
Dates: Written or electronic comments must be received by December 26, 2007. Outlines of topics to be discussed at the public hearing scheduled for January 30, 2008, at 10 a.m., must be received by January 2, 2008.
-54614 (9 pages)
Shorter URL: https://federalregister.gov/a/07-4734 Related Topics
Arbitrage Guidance for Tax-Exempt Bonds 4 actions from September 26th, 2007 to December 2013
72 FR 546606
I. Existing Regulations Back to Top
The Proposed Regulations make a number of discrete changes to the Existing Regulations. Highlighted in this preamble are certain more substantive changes which are discussed in further detail. In addition, certain more minor changes are addressed in summary form. (1) Hedges based on taxable interest rates. The Proposed Regulations make revisions to accommodate certain hedges in which floating payments under the hedge are based on a taxable interest rate and to clarify that bonds covered by such a hedge are ineligible for treatment as fixed yield bonds under the special hedging rule in § 1.148-4(h)(4).
Section 1.148-4 of the Existing Regulations sets forth rules for determining the yield on an issue of bonds for purposes of applying the arbitrage rules. In general, § 1.148-4(h) of the Existing Regulations permits issuers to compute the yield on an issue by taking into account payments under “qualified hedges.” The Existing Regulations provide two ways in which a qualified hedge can be taken into account in computing yield on the issue, known commonly as “simple integration” and “super integration.”
The IRS and the Treasury Department have determined that taxable-index hedges based on widely-used taxable indices, such as LIBOR based hedges, sufficiently improve the efficiency of the tax-exempt bond market to warrant accommodation. The Proposed Regulations accommodate these hedges by modifying (1) the provisions for “yield reduction payments,” which permit an issuer to reduce yield on an investment by making payments to the Federal government in certain permitted circumstances to comply with yield restriction rules and (2) the qualified hedge provisions. The Proposed Regulations make clear, however, that while taxable-index hedges can be qualified hedges, and therefore eligible for simple integration, they are not eligible for super integration because there is an insufficient correlation between tax-exempt bond interest rates and taxable market interest rate indices. However, the IRS and the Treasury Department understand that issuers have recently issued variable-rate bonds that bear interest equal to a percentage of LIBOR, and seek public comments on whether special accommodation under the super integration rule is required for those bond issues.
Yield reduction payments effectively integrate the yield restriction requirements with the arbitrage rebate requirements. For certain limited situations, § 1.148-5(c) of the Existing Regulations permits yield reduction payments to be paid to the United States to satisfy yield restriction requirements on certain investments. Yield reduction payments are similar to, but not identical to, rebate payments. In general, the purpose of the yield reduction payment rules is to simplify compliance with the sometimes overlapping yield restriction and arbitrage rebate requirements by allowing issuers to make payments similar to rebate payments to the United States to satisfy yield restriction and rebate in appropriate circumstances. For example, an issuer may effectively reduce the yield on an investment to a yield that will not violate the yield restriction rules and also satisfy the arbitrage rebate requirement through a yield reduction payment.
The Proposed Regulations also modify the qualified hedge provisions to provide that the floating rate on the taxable-index hedge and the variable rate on the hedged bonds will be treated as substantially the same for purposes of § 1.148-4(h)(2)(v)(B) if: (1) The difference between the two rates is not greater than one-quarter of one percent (.25 percent, or 25 basis points) on the date the issuer enters into the hedge, and (2) for a three-year period that ends on the date the issuer enters into the hedge, the average difference between the issuer's actual tax-exempt interest rate on comparable variable-rate bonds (or, if no such comparable bonds exist, a reasonable tax-exempt interest rate index, such as the SIFMA Municipal Swap Index, for that same period) and an interest rate determined in the same manner as the floating interest rate on the hedge does not exceed one-quarter of one percent (.25 percent, or 25 basis points). For example, if the floating rate on the hedge is 67 percent of LIBOR, then 67 percent of LIBOR, determined on the same days as the issuer's actual interest rates (or tax-exempt index, if applicable) are determined, is compared to the issuer's actual interest rates (or the tax-exempt index, if applicable) for the three-year period ending on the date the hedge is entered into and the differences are averaged to determine whether the average difference exceeds one-quarter of one percent. For this purpose, a reasonable sample may be used if the sample for the issuer's actual rates (or tax-exempt market index rates, if applicable) and the sample of floating rates used for the hedge are determined as of the same dates.
Under § 1.148-5(d)(3) of the Existing Regulations, investments purchased with bond proceeds must be valued at fair market value. Section 1.148-5(d)(6)(iii) of the Existing Regulations provides a safe harbor for establishing the fair market value of a guaranteed investment contract (GIC) for arbitrage purposes. That safe harbor generally relies on a prescribed bidding procedure and the receipt of at least three bids from independent parties. The bidding process requirements under the safe harbor include a requirement that all bidders be given an equal opportunity to bid with no opportunity to review other bids (that is, the “no last look” rule) and a requirement that the bid specifications be provided to prospective bidders “in writing.”
Example 2(iii)(D) in § 1.148-3(j) of the Existing Regulations has caused confusion because it could be interpreted to mean that an issuer can receive a refund of a rebate payment when the future value of such rebate payment exceeds the rebate amount on the next computation date, even though the actual amount of the previous rebate payment does not exceed the rebate amount on that next computation date. The Proposed Regulations make a technical amendment to this example to conform this example to the intended purpose of § 1.148-3(i)(1). Because the proposed change does not change the regulatory rule, but merely makes an existing example conform to that rule, the Proposed Regulations provide that the effective date for this provision is the same as the effective date for the regulatory rule. However, the IRS will not reopen rebate refund claims that have been processed before the date the Proposed Regulations are published in the Federal Register.
The Proposed Regulations make the following additional changes to the hedging rules in § 1.148-4(h) and specifically seek the following comments on the hedging rules.
a. Cost of Funds Hedges. The Proposed Regulations clarify that for purposes of applying the definition of periodic payment under § 1.446-3(e)(1) to determine whether a hedge has a significant investment element under § 1.148-4(h)(2)(ii)(A), a “specified index” under § 1.446-3(c)(2) (upon which periodic payments are based) is deemed to include payments under a cost-of-funds swap, thereby eliminating any doubt that these hedges can be qualified hedges.
b. Size and Scope of a Qualified Hedge. The Proposed Regulations add an express requirement under § 1.148-4(h)(2)(v) that limits the size and scope of a qualified hedge to a level that is reasonably necessary to hedge the issuer's risk with respect to interest rate changes on the hedged bonds. This proposed limitation is comparable to a former provision that was in the arbitrage regulations from 1993 to 1997, but was removed in connection with 1997 amendments to the Existing Regulations. The Treasury Department and the IRS believe that this principle was implicitly carried forward in the subsidiary standards under the interest-based contract requirement in the Existing Regulations in 1997. The Proposed Regulations, however, provide an explicit separate requirement to clarify the continued application of this principle.
c. Correspondence of Payments for Simple Integration. Commentators have requested guidance on what time period satisfies the rule under § 1.148-4(h)(2)(vi) that requires payments on a hedge to correspond closely in time to the payments on the hedged bonds. The Proposed Regulations add a rule for simple integration that treats payments as corresponding closely in time for this purpose if the payments are made within 60 calendar days of each other. This proposed rule contrasts with the rules for super integration, which require that payments be made within 15 days of each other. The Proposed Regulations provide a more flexible time period for correspondence of payments for simple integration purposes consistent with the fact that simple integration results in more accurate accounting for all net payments.
d. Time for Identification of Qualified Hedges. Commentators have indicated that the three-day period for identifying a hedge under § 1.148-4(h)(2)(viii) of the Existing Regulations raises practical difficulties, particularly with respect to hedges that are not entered into contemporaneously with the issuance of the hedged bonds. The Proposed Regulations extend the time in § 1.148-4(h)(2)(viii) for when an issuer must identify a qualified hedge from three days to fifteen days and clarify that these are calendar days. The Proposed Regulations, however, retain the requirement that the actual State or local governmental issuer, rather than the conduit borrower, identify the hedge because the Treasury Department and the IRS believe that it is important for State and local governments to be responsible for qualified hedges on their bonds.
e. Termination of Hedges at Fair Market Value. The Proposed Regulations clarify that under § 1.148-4(h)(3)(iv)(B), the termination payment for a termination or a deemed termination is equal to the fair market value of the hedge on the termination date.
f. Solicitation of Comment on Offsetting Hedges. The Treasury Department and the IRS have received requests for clarification of the scope of the rule that treats offsetting hedges as deemed terminations of qualified hedges under § 1.148-4(h)(3)(iv)(A). The Treasury Department and the IRS seek express public comment regarding the types of offsetting hedges that are necessary for valid business purposes and recommendations on how to clarify the scope of this rule on offsetting hedges.
The Existing Regulations provide certain preferential rules for the treatment of administrative costs to certain widely-held “external commingled funds,” as defined in § 1.148-5(e)(2)(ii)(B). Under the Existing Regulations, a fund is treated as widely held if the fund, on average, has more than 15 unrelated investors, each of which maintains prescribed minimum average investments in the fund. The Proposed Regulations make a technical change to allow additional smaller investors to invest in an external commingled fund without disqualifying the fund so long as at least 16 unrelated investors each maintain the required minimum average investments in the fund.
The Proposed Regulations make conforming changes to § 1.148-8(d) to reflect legislative changes made to section 148(f)(4)(D) by section 508 of the Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-222, 120 Stat. 345 (TIPRA). Under TIPRA, Congress eliminated the rule in § 148(f)(4)(D)(ii)(II) that permitted a pool bond issuer to ignore its pool bond issue in computing whether it had exceeded its $5 million limit for purposes of the small issuer rebate exception of section 148(f)(4)(D). Correspondingly, the Proposed Regulations eliminate the provisions in the Existing Regulations that permit a pool bond issuer to ignore the amount of its pool bond issue in determining whether the issuer meets the small issuer exception of section 148(f)(4)(D). The Proposed Regulations retain the provision that permits a State or local governmental conduit borrower to ignore the amount of certain pool bond issues in excess of the amount it borrows from that pool. Consistent with the statutory change, the Proposed Regulations provide that the change for pool bond issuers is effective for bonds issued after May 17, 2006, the effective date of the relevant provision of TIPRA.
III. Effective Dates Back to Top
The Proposed Regulations are proposed to apply to bonds sold on or after a date that is 90 days after publication of final regulations in the Federal Register, but an issuer may apply certain specified provisions of the Proposed Regulations to bonds sold before the date that is 90 days after publication of the final regulations in the Federal Register as provided in proposed § 1.148-11(k). Except for the changes to the qualified hedging rules which must be applied in their entirety, issuers that are permitted, but not required, to apply the proposed changes may apply some or all of the changes to a bond issue.
The Proposed Regulations contain a technical amendment to the example in the general arbitrage rebate rules. This change applies to bonds subject to § 1.148-3(i), the dates of applicability for which are set forth in the Existing Regulations.
The Proposed Regulations contain a special effective date provision for the regulatory change that conforms the arbitrage regulations to the legislative change made to the small issuer rebate exception for pooled bond issuers. This change applies to bonds issued after May 17, 2006, the effective date of the relevant provision of TIPRA. Effect on Other Documents Back to Top
1. Add entry for new paragraph (d)(4) in the table of contents for § 1.148-3.
2. Revise entry for paragraph (d) in the table of contents for § 1.148-8.
3. Remove entries for paragraph (d)(1) and paragraph(d)(2) in the table of contents for § 1.148-8.
4. Add entries for new paragraphs (k), (k)(1), (k)(2),(k)(3) and (k)(4) in the table of contents for § 1.148-11.
§ 1.148-0 Scope and Table of Contents.
§ 1.148-8 Small issuer exception torebate requirement.
§ 1.148-11 Effective dates.
Example 2. * * * Back to Top
(A) * * * For purposes of applying the definition of periodic payment under § 1.446-3 to determine whether a hedge has a significant investment element under this paragraph (h)(2)(ii)(A), the definition of “specified index” under § 1.446-3 (upon which periodic payments are required to be based) is deemed also to include payments an issuer receives under a hedge that are computed to be equal to the issuer's cost of funds, such as the issuer's actual market-based tax-exempt variable interest rate on its bonds.
(2) A difference resulting from the payment of a fixed premium for a cap (for example, payments for a cap that are made in other than level installments).
§ 1.148-5 Yield and valuation of investments.
(i) Nonpurpose investments allocated to proceeds of an issue that qualified for certain temporary periods.* * *
(ii) Investments allocable to certain variable yield issues.* * *
(iii) Nonpurpose investments allocable to certain transferred proceeds.* * *
(iv) Purpose investments allocable to certain qualified student loans.* * *
(v) Nonpurpose investments allocable to gross proceeds in certain reserve funds. Nonpurpose investments allocable to gross proceeds of an issue in a reasonably required reserve or replacement fund or a fund that, except for its failure to satisfy the size limitation in § 1.148-2(f)(2)(ii), would qualify as a reasonably required reserve or replacement fund, but only to the extent the requirements in paragraphs (c)(3)(v)(A) or (B) of this section are met. This paragraph (c)(3)(v) includes nonpurpose investments described in this paragraph that are allocable to transferred proceeds of an advance refunding issue, but only to the extent necessary to satisfy yield restriction under section 148(a) on those proceeds treating all investments allocable to those proceeds as a separate class.
(vii) Investments allocable to replacement proceeds under a certain transition rule.* * *
(A) The issuer has entered into a qualified hedge under § 1.148-4(h)(2) with respect to all of the variable-yield bonds of the issue allocable to the yield restricted defeasance escrow and that hedge is in the form of a variable-to-fixed interest rate swap under which the issuer pays the hedge provider a fixed interest rate and receives from the hedge provider a floating interest rate;
(B) External commingled funds.* * * For purposes of this paragraph (e)(2)(ii)(B), a fund is treated as widely held only if, during the immediately preceding fixed, semiannual period chosen by the fund (for example, semiannual periods ending June 30 and December 31), the fund had a daily average of more than 15 investors that were not related parties, and at least 16 of the unrelated investors each maintained a daily average amount invested in the fund that was not less than the lesser of $500,000 and one percent (1%) of the daily average of the total amount invested in the fund (with it being understood that additional smaller investors will not disqualify the fund). * * *
(i) Section 1.148-3(d)(1)(iv) and § 1.148-3(d)(4) may be applied for bond years ending on or after the date of publication of the proposed regulations in the Federal Register for bonds to which 1.148-3(d)(1)(iv) applies.
(iii) Sections 1.148-4(h)(2)(ii)(A), 1.148-4(h)(2)(v), 1.148-4(h)(2)(vi), 1.148-4(h)(2)(viii), 1.148-4(h)(3)(iv)(B), and 1.148-4(h)(4)(i)(C) may be applied, in whole but not in part, for qualified hedges entered into on or after the date of publication of the proposed regulations in the Federal Register for bonds to which § 1.148-4(h) applies.
(v) Section 1.148-5(d)(6)(iii)(A) may be applied to guaranteed investment contracts entered into on or after the date of publication of the proposed regulations in the Federal Register for bonds to which § 1.148-5(d)(6)(iii) applies.
(3) Rebate overpayment recovery. Section 1.148-3(j) applies to bonds subject to § 1.148-3(i).