Opinion ID: 410333
Heading Depth: 2
Heading Rank: 3

Heading: Reasonableness of Commissioner's Regulations

Text: 36 Following passage of the Act, the Commissioner regularly interpreted Section 103(c) as being aimed at unjustified arbitrage profits. It published Temporary Regulations and thereafter Proposed Regulations which took the position that, in computing yield, the actual bid price to the issuer--taking into account any discount--should be used. 16 Treasury repeatedly emphasized that 37 Congress sought to prevent advance refundings which generate arbitrage--that is, profits based upon the difference between the cost to the issuer of the advance refunding issue and the returns from investment of bond proceeds   . 38 Treasury News Release, September 24, 1976. Although both Congress and the Treasury were concerned with states and municipalities acting as conduits, Treasury continuously interpreted the statute to be limited to preventing these local bodies from earning arbitrage profits on the interest differential between tax-exempt bonds and the non-exempt bonds of the federal government. 39 By 1978, however, states and municipalities were refunding bonds in increasingly large numbers, and the expense to the Federal Treasury was growing correspondingly. In Treasury's view the ability to earn back administrative costs and discount was contributing to the payment of excessive underwriters' fees and other issuance expenses, as well as encouraging the issuance of economically unsound refundings. See General Statement of Policy preceding proposed amendments to Proposed Treasury Regulations Secs. 1.103-13, 1.103-14, and 1.103-15, 43 Fed.Reg. 39822-39823 (1978). As a consequence, Treasury changed its official position regarding the calculation of permissible yields. 17 It announced that for purposes of computing yield, administrative costs [should] not be taken into account and that the purchase price would henceforth be the initial offering price to the public (excluding bond houses, brokers, and other intermediaries). Treas.Reg. Sec. 1.103-13(d)(1) and (d)(2) (1978). Thus, Treasury changed the focus of its regulations from attacking arbitrage profits to neutralizing the possible incentives that Section 103 created for the issuance of local government securities. 40 As originally passed by the House, Section 103(c) would indeed have given the Treasury wholesale discretion to define arbitrage bonds in this manner and to pursue this broad objective. 18 But Treasury asked the Senate for a more limited grant of authority; it recommended that the bill provide that bonds would be arbitrage bonds 41 if, under regulations prescribed by the Secretary or his delegate, the circumstances (including but not limited to the terms of the obligation, the specified purpose of the issue, the nature of the security provided for the obligation, and all other relevant facts) demonstrate that the result of the issuance is the realization of an arbitrage profit from reinvestment of the proceeds in higher yield securities.    42 Technical Memorandum of Treasury Position, supra, at 117 (emphasis added). But, in the end, the Senate Finance Committee rejected a delegation even this broad. That committee--and ultimately Congress--adopted a more mechanical test which provided that bonds were arbitrage bonds if the proceeds were invested in securities producing a materially higher yield than the yield on the bonds themselves. 26 U.S.C. Sec. 103(c) (1976). Furthermore, the statute specifically required the yield computation to be made taking into account any discount. Id. Thus, Congress implicitly rejected any grant of unlimited authority to Treasury to define arbitrage bonds or to manipulate the components of the yield calculation in response to changing incentives of local governments to issue bonds. Congress instead passed legislation limited to eliminating arbitrage profits and thereby avoided (and did not give Treasury authority to address) the more slippery problem of local governments acting as investment conduits. 19 43 The regulatory authority that Congress did grant to the Commissioner merely authorized the IRS to adopt such regulations as may be necessary to carry out the purposes of this subsection. 26 U.S.C. Sec. 103(c)(6). But such regulation must be directed at the elimination of arbitrage profits. Where regulations go beyond that purpose, they are invalid as an unreasonable exercise of the rulemaking power. See, e.g., American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct.Cl.1979). Since these regulations restrict the freedom of states and municipalities to invest the proceeds of their issuances to a degree Congress did not envision, they must be invalidated as exceeding the Commissioner's authority. 44 The Commissioner raises the legitimate concern that invalidating these regulations will lead both to increased numbers of unsound bond refundings and to excessive underwriters' fees and issuance costs. As support for this concern, the Commissioner notes that the volume of advance refundings increased from $56 million in 1970 to approximately $9.2 billion in 1978, and then dropped to approximately $1.8 billion after the first full year that the amended regulations were in existence. Brief for appellant at 15 n.6. The Commissioner interprets this data as conclusively proving that the ability to earn back underwriters' discount and issuance expenses has prompted many states and municipalities to issue advance refunding even though, from a societal standpoint, the overall cost of the bonds might outweigh the benefits. 20 Even if the Commissioner's interpretation of the data is correct, however, Congress has not given him the authority to address the problem in the manner that he has chosen. 21 Congress delegated him the authority only to eliminate arbitrage profits, and not the authority to prevent the issuance of bonds where tax incentives play a marginally determinative factor in the states' or municipalities' decisions. 45 Still, states and municipalities should be chary in their issuance of tax-free bonds and their subsequent reinvestment of the proceeds. It is a fundamental principle of state and municipal bond law that the issuing body must have a legitimate, independent purpose to sell debt instruments in order to raise moneys. L. JONES, THE LAW OF BONDS AND BOND SECURITIES Sec. 12 (1950). If no such purpose exists, the issuance would be violative of local law, and should not qualify for the tax exemption that Section 103 provides for validly issued municipal and state bonds. Moreover, the Commissioner has other powerful and permissible weapons in his regulatory arsenal for attacking excessive underwriter discounts and issuance costs. The Commissioner can legally limit the amounts that states and municipalities can legitimately incur for these purposes. He has already done so for fees paid for financial consulting. See Proposed Treas.Reg. Sec. 1.103-13(c)(1)(ii), 41 Fed.Reg. 47683 (1976). So, if such excesses appear in the future, the Commissioner may well be able to attack them straightforwardly as unnecessarily incurred. But the Commissioner cannot indirectly attack them through regulations that are inconsistent with the underlying purpose, and that rely on an awkward construction of the words, of the statute.