24 January 2017 Final regulations define issue price for purposes of arbitrage investment restrictions In final regulations (TD 9801), the IRS addressed the definition of issue price for purposes of the arbitrage investment restrictions applicable to tax-exempt and other tax-advantaged bonds. The final regulations affect state and local governments that issue these bonds. Section 148 imposes arbitrage investment restrictions on the investment of proceeds of tax-exempt bonds and requires issuers to rebate to the federal government certain excess earnings above the yield on tax-exempt bonds. The current regulations under Section 148 include comprehensive final regulations that the IRS issued in 1993 and final regulations (TD 9777; see Tax Alert 2016-1261) issued in July 2016 (together, the Existing Regulations). The Existing Regulations generally follow the "issue price" definition used for computing original issue discount on debt instruments under Section 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%. In 2013, the IRS issued proposed regulations (the 2013 Proposed Regulations) intended to reflect changes in the market, simplify the rules, address technical issues and clarify certain terms (REG-148659-07, Tax Alert 2013-1798). The 2013 Proposed Regulations revised the definition of "issue price" under Reg. Section 1.148-1, defining "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 is 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. In addition, to provide relief when an issuer needs to estimate the yield on the issue before the actual issue price can be determined under the proposed rules, the 2013 Proposed Regulations included a rule permitting the issuer to make curative "yield reduction payments" to the IRS to reconcile differences between expected and actual issue prices. In response to the comments, the IRS and Treasury withdrew the portion of the 2013 Proposed Regulations revising the definition of "issue price" and issued new proposed regulations (REG-138526-14; Tax Alert 2015-1219) (the 2015 Proposed Regulations) that would use actual sales to determine issue price, but revert to the definition of substantial amount equaling 10%. In addition, 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. A public hearing was held on the 2015 Proposed Regulations in October 2015. The final regulations adopt the 2015 Proposed Regulations and incorporate some of the public comments received. Consistent with Section 148(h), the 2015 Proposed Regulations retained the rule that issue price generally will be determined under the rules of Section 1273 and 1274. The 2015 Proposed Regulations added a general rule that the issue price of bonds issued for money is the first price at which a substantial amount of the bonds are sold to the public. The 2015 Proposed Regulations retained the rule in the Existing Regulations that 10% is the measure of a substantial amount. The 2015 Proposed Regulations also proposed to retain the rule that the issue prices of bonds with different payment and credit terms are determined separately. Commenters recommended adding a specific rule to address the treatment of private placements not involving underwriters, such as bank loans, and also clarifying that an issuer may use the general rule to determine issue price even if the issuer had sought to use the special rule based on the initial offering price to the public. The IRS and the Treasury agreed with the recommendations provided by the commentators and drafted the final regulations to retain the rules in the Existing Regulations and the general rule of the 2015 Proposed Regulations that, "for bonds issued for money, the issue price is the first price at which a substantial amount of the bonds is sold to the public, and a substantial amount is [10] percent." In addition, the final regulations also: — Expressly provide that, for a bond issued for money in a private placement to a single buyer that is not an underwriter or a related party to an underwriter, the issue price of the bond is the price paid by that buyer. — Clarify that, for the bonds for which more than one rule for determining the issue price is available, an issuer may select the rule it will use to determine the issue price for the bonds at any time on or before the issue date of the bonds. On or before the issue date of the bonds, the issuer must identify the rule selected in its books and records maintained for the bond. The 2015 Proposed Regulations included a special rule to allow an issuer to treat an initial offering price to the public as the issue price as of the sale date, as long as certain requirements were met. One of these requirements was that the lead underwriter certify, among other things, that no underwriter would sell bonds after the sale date and before the issue date at a higher price than the initial offering price unless the higher price resulted from a market change after the sale date that the underwriter could document (referred to as the hold-the-offering-price requirement). Some commenters expressed concern that "the requirement for the lead underwriter to provide certification as to the actions of the entire underwriting syndicate or selling group was overly broad." Instead, they recommended that members of an underwriting syndicate or selling group should be allowed "to agree individually to act in accordance with the specific matters required under the special rule." As a result, the final regulations now reflect that "each underwriter is individually or severally responsible for its agreement (rather than jointly responsible with other underwriters)." In response to objections to the hold-the-offering-price requirement as potentially unworkable, the final regulations modify the requirement. Underwriters will be required "to hold the price for offering and selling unsold bonds at a price that is no greater than the initial offering price to the public for a shorter period than ends on the earlier of: (1) the close of the date that is the [fifth] business day after the sale date or (2) the date on which the underwriters have sold a substantial amount of the bonds to the public." Also, responding to "overwhelming negative comments," the IRS has removed the proposed market change exception from the final regulations. Further, the final regulations clarify that an underwriter may not sell bonds for a higher price than the initial offering price to the public. The preamble notes that, under the final regulations, an issuer may treat the initial offering price to the public as the issue price as of the sale date if: (1) The underwriters offered the bonds to the public at a specified initial offering price on or before the sale date, and the lead underwriter in the underwriting syndicate or selling group (or, if applicable, the sole underwriter) provides, on or before the issue date, a certification to that effect to the issuer, together with reasonable supporting documentation for that certification such as a copy of the pricing wire or equivalent communication; and (2) each underwriter agrees in writing that it will neither offer nor sell the bonds to any person at a price that is higher than the initial offering price during the period starting on the sale date and ending on the earlier of the close of the [fifth] business day after the sale date, or the date on which the underwriters have sold a substantial amount of the bonds to the public at a price that is no higher than the initial offering price to the public. The preamble notes that many commentators, including four states, "strongly urged a streamlined special rule for competitive sales to allow the reasonably expected initial offering price to the public reflected in the winning bid in a competitive sale to establish the issue price without a hold-the-offering-price requirement or other restrictions" and "suggested that the public bidding process for pricing municipal bonds in competitive sales itself provides a sufficient basis to achieve the best pricing for users." The final regulations adopt these recommendations and provide that, "for bonds issued for money pursuant to an eligible competitive sale, an issuer may treat the reasonably expected initial offering price to the public of the bonds as the issue price of the bonds as of the sale date if the issuer obtains a certification from the winning bidder regarding the reasonably expected initial offering price to the public of the bonds upon which the price in the winning bid is based." The final regulations define a competitive sale as a sale of bonds by an issuer to an underwriter who is the winning bidder in a bidding process in which the issuer offers the bonds for sale to underwriters at specified written terms and that meets these requirements: (1) The issuer disseminates a notice of sale to potential underwriters in a manner reasonably designed to reach potential underwriters. (3) The issuer receives bids from at least three municipal bond underwriters with industry reputations for underwriting new issuances of municipal bonds. In response to comments, the final regulations do not include a standard proposed in the 2015 Proposed Regulations regarding reliance on underwriters' certifications. A due diligence standard currently in the Existing Regulations will apply instead to any certification under the final regulations. These final regulations provide some stability for tax-exempt bond issuers and conduit borrowers on the issue price definition in helping determine yield for arbitrage restriction calculations that apply to tax-advantaged bonds. The issue price definition completes the recently released July 18, 2016, Section 148 final regulations, which avoided defining issue price in creating a new standard for determining arbitrage restriction. In defining "issue price," the Treasury retained a majority of the rules from the 2015 Proposed Regulations, while considering and accepting several modifications offered by commentators. Specifically, the final regulations do not change the general rule from the Existing and Proposed Regulations, but carve out two special rules, and add an option for selecting among both rules when more than one applies to a single issue. These regulations do not change how issue price is used for purposes of calculating arbitrage under Section 148, but they should be carefully reviewed in determining what the issue price is. These regulations should also be considered together with the recent Section 148 regulations issued in July 2016 regarding the new and updated guidance on determining arbitrage restrictions. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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