21 July 2016 IRS finalizes arbitrage restriction rules applicable to exempt bonds In final regulations (TD 9777), the IRS has modified the Section 148 arbitrage restriction rules applicable to tax-exempt and tax-advantaged bonds, with the aim of updating and simplifying the existing rules, addressing some technical issues and making the rules more administrable. Section 148 imposes arbitrage investment restrictions on the investment of proceeds of tax-exempt bonds and requires issuers to rebate certain excess earnings above the yield on tax-exempt bonds to the federal government. Prior to the new final regulations, the regulations under Section 148 consisted of comprehensive final regulations that the IRS issued in 1993, along with some subsequent modifications (together, the Existing Regulations). The Existing Regulations generally follow the "issue price" definition used for computing original issue discount on debt instruments under Sections 1273 and 1274, with certain modifications. They apply a reasonable-expectations (rather than actual-sales) standard for determining the issue price of bonds that are publicly offered. That is, the issue price used in determining the yield on the issue is based on the first price at which a substantial amount of the bonds is reasonably expected to be sold. The Existing Regulations define "substantial amount" as 10%. The IRS proposed a number of changes to the Existing Regulations in 2007 (the 2007 Proposed Regulations), such as addressing a municipal market development in which issuers seek to modify interest rate risks by entering into hedging transactions that are based on taxable interest rate indexes. The 2007 Proposed Regulations also proposed revising an investment bidding safe harbor, removing the authority in the Existing Regulations to permit issuers of certain bonds to compute a single joint bond yield for purposes of applying the arbitrage restrictions to two or more bond issues and clarifying the amount that an issuer is entitled to receive under a rebate refund claim. In 2013, the IRS issued additional proposed regulations (the 2013 Proposed Regulations) with changes to the Existing Regulations. Among other changes, the 2013 Proposed Regulations included a revised definition of "issue price" under Reg. Section 1.148-1. Specifically, the 2013 Proposed Regulations defined "issue price" to be the first price at which a substantial amount of the bonds is actually sold to the public. In addition, they re-defined "substantial amount" from 10% to 25%. Also, for this purpose, they defined "public" as any person other than an "underwriter" — which they defined as any person purchasing bonds from the issuer for the purpose of affecting the original distribution bonds as opposed to holding the bonds for investment. See Tax Alert 2013-1798{}. In 2015, the IRS issued new proposed regulations (the 2015 Proposed Regulations), withdrawing, in part, the 2013 Proposed Regulations. Specifically, in response to comments, the IRS decided to withdraw the portion of the 2013 Proposed Regulations revising the definition of "issue price." Instead, the 2015 Proposed Regulations would use actual sales to determine issue price, but revert to the definition of substantial amount equaling 10%. In addition, in response to concerns regarding the insufficient sales of bonds resulting in uncertainty about the determination of issue price as of the sale date, the 2015 Proposed Regulations provided an alternative method of determining issue price for bonds with insufficient sales as of the sale date to determine issue price based on a substantial amount of actual sales. See Tax Alert 2015-1219{}. The Final Regulations adopt, with changes, the provisions of the 2007 and 2013 Proposed Regulations. Some of the most significant provisions and changes in the Final Regulations are discussed below. The 2013 Proposed Regulations proposed to shorten the bond maturity necessary to satisfy the safe harbor for most short-term working capital financings from two years to 13 months. The Final Regulations extend this safe harbor to all working capital expenditure financings, rather than just those for restricted working capital expenditures. The 2013 Proposed Regulations also proposed to add a new safe harbor that would prevent the creation of replacement proceeds for longer-term working capital financings to enhance certainty for issuers experiencing financial distress. The proposed rule would require an issuer to test for available amounts on the first day of its fiscal year and to apply such amounts to redeem or invest in eligible tax-exempt bonds within 90 days. The Final Regulations generally adopt this rule, with some revisions to allow greater flexibility to address short-term cash flow deficits. The Final Regulations adopt a rule in the 2013 Proposed Regulations broadening the 13-month temporary period for restricted working capital expenditures to include all working capital expenditures. The Final Regulations adopt a rule included in the 2007 Proposed Regulations increasing the arbitrage rebate computation credit and indexing it to inflation based on the Consumer Price Index. The 2007 Proposed Regulations looked to eliminate a provision in the Existing Regulations that allows for a joint bond yield calculation for two or more issues of qualified student loan or qualified mortgage bonds. This proposal was accepted by the Final Regulations and a provision was added to allow for yield restriction payments for these types of bonds. The Final Regulations also adopt a 2007 proposal to simplify the yield calculations for certain callable bonds issued with significant amounts of bond premium to focus on the redemption date that results in the lowest yield on the particular premium bond. Regarding taxable index hedges, the Final Regulations clarify that a taxable index hedge is an interest-based contract, and eliminate the interest rate correlation test for taxable index hedges, which was part of the 2007 Proposed Regulations. They also clarify that the difference between the interest rate used on the hedged bonds and that used to compute payments on the hedge will not prevent the hedge from being an interest-based contract if the two interest rates are substantially similar. The Final Regulations further adopt a 2007 proposal to add an express requirement limiting the size and scope of a qualified hedge to a level that is reasonably necessary to hedge the issuer's risk of interest rate changes on the hedged bonds. The 2007 Proposed Regulations also included a rule to extend the time for an issuer to identify a qualified hedge from three to 15 calendar days; the Final Regulations clarify that this 15-day period begins on the date on which the parties enter into a binding agreement to enter into the hedge. The Final Regulations also adopt guidance included in the 2013 Proposed Regulations on the treatment of modifications and terminations of qualified hedges, but remove assignment of a hedge as an example of a modification. The Final Regulations simplify the treatment of a qualified hedge upon a refunding of the hedged bonds when no actual termination of the associated hedge occurs, as proposed in 2013. They also retain and simplify, in part, a 2013 proposed rule to modify the amounts taken into account for a deemed termination or actual termination of a qualified hedge. The Final Regulations expand the situations in which payment of yield reduction payments to the US may satisfy yield restriction requirements on certain investments, as proposed in 2007. The Final Regulations clarify that an issuer may make yield reduction payments if it enters into an agreement to purchase investments on a date when State and Local Government Series securities (SLGS) sales are suspended. Regarding the valuation of investments, the Final Regulations adopt comments urging the addition of: (1) a clarification that purpose investments must be valued at present value at all times; and (2) rules clearly distinguishing between purpose and nonpurpose investments. The Final Regulations also adopt a 2013 proposed rule to clarify that, on the original purchase date only, the fair market value of such an obligation, including a SLGS security, is its purchase price. The Final Regulations adopt a 2007 proposal to amend the safe harbor for electronic bidding procedures, and, in response to comments, clarify that bids must be in writing and timely disseminated. They also clarify that a writing may be: (1) in electronic form; and (2) disseminated by fax, email, an internet-based website or other electronic medium that is similar to an internet-based website and regularly used to post bid specifications. When an issuer enters into a transaction for a principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner inconsistent with the purposes of Section 148, the 2013 Proposed Regulations proposed to amend the Commissioner's authority to depart from the arbitrage regulations from that "necessary to clearly reflect the economic substance of the transaction" to that "necessary to prevent such financial advantage." In response to concerns that this would give unduly broad discretion to the Commissioner, the Final Regulations limit the Commissioner's authority to that necessary "to reflect the economics of the transaction to prevent such financial advantage." The Final Regulations provide additional guidance to tax-exempt bond issuers on the arbitrage restrictions that apply to tax-advantaged bonds. While the Final Regulations consolidate and finalize arbitrage proposals made in the 2007 and 2013 Proposed Regulations, they also adopt several significant changes. Some of these changes include providing safe harbors in both short-term and longer-term working capital financings when bonds are issued to finance operating or other non-construction costs, expanding yield reduction payments for advance refundings to new allowable scenarios, and limiting the Commissioner's authority in finding an issuer entered into a transaction inconsistent with the purposes of Section 148. It should be noted that the Final Regulations do not, however, make any changes to the current issue price rules. Specifically, the 2015 Proposed Regulations to determine issue price, as well as the alternative method to determine issue price for a bond with insufficient sales still remain in the "proposal" state. The Final Regulations take effect July 18, 2016. They will generally apply to bonds sold on or after October 17, 2016. Tax-exempt bond issuers can also elect to apply certain provisions of the Final Regulations to bonds issued before that date. Issuers and Conduit Borrowers of tax advantaged bonds should consider these modifications when calculating their arbitrage rebate calculations and applicable yield restriction payments. The modified safe harbors may influence timing of when debt is put into place when compared to projected cash flows. Consideration should also be given to investment strategies that could include investing in other tax-exempt bonds or even calling bonds when it is advantageous. Issuers should also take note of the new clarifications regarding hedges in the calculation of their bond yield. Modifications in this calculation by even a few basis points could result in significant amounts of liability to the Issuers and/or Conduit Borrowers. Although the calculations required under Section 148 are intricate, the ultimate penalty is that a bond issue could be declared taxable, so care should be taken to observe these regulations. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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