The IRS has released proposed regulations (REG-106977-18, "the Proposed Regulations") clarifying the definition of "investment-type property" for purposes of the arbitrage investment restrictions applicable to tax-exempt and other tax-advantaged bonds. The Proposed Regulations would create an explicit exception for investments in capital projects that further the public purposes for which the bonds were issued.

Background

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 certain limited-scope amending regulations issued since that time (together, "the Existing Regulations").

In general, a taxable "arbitrage bond" under Section 148 means any bond issued as part of an issue any portion of whose proceeds are reasonably expected to be used, or are intentionally used, to acquire "higher yielding investments" (as defined in Section 148(b)(1)). For this purpose, investments include "investment-type property" — defined in Reg. Section 1.148-1(e)(1) of the Existing Regulations generally as certain property "held principally as a passive vehicle for the production of income."

Proposed regulations

The Proposed Regulations respond to requests from institutional investors for the IRS to clarify the scope of the regulatory definition of "investment-type property" under Reg. Section 1.148-1(e)(1) to ensure that the definition does not impede capital investment in public infrastructure. In support of the clarification which the IRS offers in the Proposed Regulations, the IRS cites the legislative history of Section 148. Specifically, in the preamble to the Proposed Regulations, the IRS notes that the legislative history indicates that the restriction on investment-type property is not intended to apply to "real or tangible property acquired with bond proceeds for reasons other than investment (e.g., courthouse facilities financed with bond proceeds)."

To provide the clarity sought by investors, and in accordance with IRS interpretation of congressional intent, the Proposed Regulations would create an express exception to the definition of "investment-type property" for capital projects that further the public purposes for which the tax-exempt bonds were issued. The preamble states that such property would not include, for example, "a courthouse financed with governmental bonds or an eligible exempt facility under [Section] 142, such as a public road, financed with private activity bonds."

The Proposed Regulations are proposed to apply to bonds sold on or after the date that is 90 days after the date final regulations are published. Nonetheless, the IRS states that issuers may apply the Proposed Regulations to bonds that are sold before that date.

Implications

In an attempt to facilitate additional investment in public infrastructure, these proposed regulations would clarify the Section 148 regulations to investors in tax-advantaged bonds. Although legislative intent will now be codified, it is unclear how much this will actually change current practice, as bond issuers and their attorneys have commonly relied upon legislative intent and have not considered such capital projects as investment-type property for purposes of the arbitrage rebate calculation.

These proposed regulations do not remove the need for arbitrage rebate analysis, nor change for the most part when and how it is calculated. They also do not change any of private business use rules related to the tax-exempt bonds. All of these must be monitored after the bonds are issued to ensure that the tax-advantaged status of the bonds continues to be in place.

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