Opinion ID: 410333
Heading Depth: 2
Heading Rank: 1

Heading: Interpretation of Term Yield

Text: 12 As previously noted, Section 103(c)(2) deems bonds to be arbitrage bonds if the proceeds will produce 13 a yield over the term of the issue which is materially higher (taking into account discount or premium) than the yield on    [the] obligation [itself]   . 14 The Tax Court held that while the language of Section 103(c)(2) is far from clear, it seemingly requires a comparison between the rate of return the State as bond issuer earns on its investment in U.S. Treasury certificates and the rate of return the first purchaser earns on the State's bonds. 77 T.C. at 669. The Tax Court's position essentially is that the term yield refers to the issuer's--the state government's--cost of money: the cost of refunding one issue and of purchasing another. Since discount and issuance expense are part of the cost of money, the Tax Court concluded that the State should be able to include them in the yield calculation. 15 The Commissioner contends, however, that the Tax Court applied two different interpretations of the term yield--the first referring to the rate of return to the State as holder of federal obligations, and the second referring to the cost to the State as issuer of its own bonds. Giving two meanings to the same term in the same section violates a cardinal rule of statutory construction, and the Commissioner therefore urges that the Tax Court be reversed. The Commissioner would instead require states and municipalities to calculate yield in terms of the rate of return to the respective holders: the purchasing public and the issuer. This calculation, he contends, would give consistent meaning to the term yield in Section 103(c)(2). 16
17 The State and the Tax Court present the better construction of the statutory term. Yield has a common and accepted meaning: it is the economic return on a debt instrument. THE AMERICAN COLLEGE DICTIONARY 1415 (1962); 1 S. LEVINE, FINANCIAL ANALYST'S HANDBOOK 339 (1975); G. MUNN & F. GARCIA, ENCYCLOPEDIA OF BANKING AND FINANCE 948 (7th ed. 1972). The Treasury regulation that defines the term yield accepts this common meaning by defining it to be the rate which, when used in computing the present worth of all payments of principal and interest to be paid on the obligation, produces an amount equal to the purchase price. Treas.Reg. Sec. 1.103-13(c)(1) (1978). Yield therefore changes whenever a different purchase price is paid. But whenever a bond is sold--from state to underwriter or from underwriter to public--a different purchase price is paid, and a different yield must result. Yield can be consistently determined only by using the purchase prices in the transactions to which the State was a party--the purchase price paid to the State for its bonds and the purchase price paid by the State for the U.S. Treasury certificates. It is the State that borrows money, and it is the State that buys Treasury certificates; only the State can earn arbitrage profits, and only the State can eliminate those profits by restricting the yield of its investment. By interpreting the relevant purchase prices to be those in the transactions to which the State was a party, the Tax Court used the same parameter in calculating the permissible yield, and thus applied one (not two) interpretation(s) of the statutory term. 18 The Commissioner's argument--that the relevant purchase price of the State's issuance is the one paid by the public--makes sense only if the price at which an underwriter resells the bonds to the public can be attributed to the State. If attribution is possible, then the effective price would not be a discounted one and the effective yield to the State would be higher. But attribution is not possible in this case: The proposed bond sale is to be undertaken pursuant to sealed bids, the purchaser will be the one making the best offer, and the purchaser will have no continuing obligation to the State. The important incidents of ownership--especially the risk that the value of the bonds may rise or fall--shifts to the underwriter, and the discount on par is a genuine reduction in the purchase price. Thus, the discount should be taken into account in computing the rate that makes the present worth of the future principal and interest payments equal to that purchase price. 19 The most natural reading of the statute supports the Tax Court's and the State's interpretation. To begin with, the statute expressly contemplates that discounts should be taken into account in calculating yield. 12 Congress specifically provided that arbitrage bonds would exist only if the proceeds available from the sale of the bonds were invested in taxable obligations with a yield materially higher than the yield on the bonds themselves, taking into account any discount incurred. 26 U.S.C. Sec. 103(c)(2)(A) (1976). Congress' specific reference to discount was consistent with a substantial body of case law and published IRS rulings that existed when Section 103 was enacted. See, e.g., United States v. Midland-Ross Corp., 381 U.S. 54, 57, 85 S.Ct. 1308, 1310, 14 L.Ed.2d 214 (1967) ([D]iscount serves the same function as stated interest    ; it is simply 'compensation for the use or forebearance of money.' ); Rev.Rul. 60-210, 1960-1 C.B. 38 (discount at which bonds and similar obligations were issued constitutes compensation    and, hence, was the equivalent for Federal income tax purposes) (emphasis in original). Congress was genuinely attempting to compare the cost to the state of issuing debt with the actual return to the state on the debt it purchases, and therefore specifically stated that discount should be taken into account. See Helvering v. Union Pacific R. Co., 293 U.S. 282, 283, 286, 55 S.Ct. 165, 166, 167, 79 L.Ed. 363 (1934). Second, the statute uses the term yield both for bonds issued by the State and for securities acquired by the State. The key denominators in the statute are the purchase prices in transactions to which the State was a party; the determination of whether the State will make arbitrage profits can be comfortably made only by using these purchase prices. The Commissioner encourages the awkward construction that would require the State to compute yield by reference to two transactions, one in which the State is a party, and one in which it is not. 20
21 Deciding whether the Tax Court permissibly allowed the State to include issuance costs in the yield calculation is, however, a more difficult issue. While the term discount explicitly appears in Section 103(c), the term issuance expenses does not. Thus, Congress may intentionally have drawn a distinction between discount and issuance expenses in identifying precisely which costs the State could take into account in determining the permissible reinvestment yield. But such a congressional intent is unlikely. Issuance expenses--legal fees, printing costs, advertising expenses, and so on--are outlays made to procure money, are incurred directly in connection with the bond issuance, and effectively reduce the money available from the issuance. They thereby reduce the real economic value of the debt instrument to its issuer. When Congress required states and municipalities to restrict their reinvested proceeds to yields not materially higher than the yields on their Section 103 issuances, there had been a long and consistent practice of requiring issuance expenses to be treated the same as discounts. The Treasury had for years been unable to draw a distinction between expenses [like bond discount] and other expenses incidental to the issuance of the bonds   . G.C.M. 14349, XIV-1 C.B. 36 (1935). Nor had the courts drawn such a distinction. See Denver & Rio Grande Western R. Co., 32 T.C. 43, 51 (1959), Acq. 1959-2 C.B. 4, aff'd on other issues, 279 F.2d 368 (10th Cir. 1960); Leach Corporation, 30 T.C. 563, 579 (1958), Acq. 1959-1 C.B. 4; Julia Stow Lovejoy, 18 B.T.A. 1179, 1182 (1930); Chicago, Rock Island & Pacific R. Co., 13 B.T.A. 988, 1035 (1928). Since Congress created a very mechanical test for identifying arbitrage bonds, it is unlikely that it meant to draw, or to give the IRS discretionary authority to create, a distinction which had not previously existed. In short, the most natural reading of both the statute and the commonly accepted meaning of the term yield calls for including both discount and issuance expenses in the determination of purchase price (and the calculation of yield).