The IRS has issued final regulations (TD 9854) regarding the arbitrage investment restrictions under Section 148 applicable to tax-exempt bonds and other tax-advantaged bonds issued by state and local governments. The regulations clarify the definition of "investment-type property" by providing an exception for investment in capital projects used in furtherance of the public purposes of the bonds.

Background

Interest on state or local bonds may not be excluded from a bondholder's gross income if the bonds are arbitrage bonds under Section 148. Section 148(a) defines an arbitrage bond generally as any bond that is part of a bond issue for which the proceeds are reasonably expected to be used, or are intentionally used, to acquire "higher-yielding investments" or to replace funds used in this manner.

Investment property is defined under Section 148(b)(2) as including any security, obligation, annuity contract or investment-type property, as well as certain residential rental properties. Investment-type property includes any property, other than securities, obligations, annuity contracts and covered residential rental property for family units under Section 148(b)(2)(A), (B), (C) and (E) "'that is held principally as a passive vehicle for the production of income'" (Reg. Section 1.148-1(e)(1)).

Institutional investors suggested that the IRS clarify the scope of the definition of investment-type property under Reg. Section 1.148-1(e)(1) "to ensure that the definition does not impede greater investment in public infrastructure," the Preamble to the final regulations states.

According to the Preamble, legislative history "indicates that Congress intended to limit the scope of the arbitrage restriction on investment-type property so that it did not extend to investments in capital projects in furtherance of the public purposes of the bonds."

Final regulations

Proposed regulations (REG-106977-18), published in June 2018, clarified the scope of the investment-type property definition consistent with congressional intent by proposing an exception to the definition for certain capital projects that further the public purposes for which the exempt bonds were issued. The IRS received four comments on the proposed regulations, all requesting that they be finalized "to allow greater capital investment in public infrastructure." Having received no unfavorable comments, the IRS has finalized the underlying regulations with no substantive changes. (For more on the proposed regulations, see Tax Alert 2018-1234.)

Under Reg. Section 1.148-1(e)(4) of the final regulations, investment-type property does not include real or tangible personal property used in furtherance of the public purpose for which the tax-exempt bonds are issued. The Preamble offers two examples of projects that would not be considered investment-type property: a courthouse financed with government bonds; and a public road, or other eligible exempt facility under Section 142, financed with private activity bonds.

Applicability dates and reliance

The final regulations' definition of investment-type property applies to bonds sold on or after July 8, 2019 (90 days after the regulations were published in the Federal Register on April 9, 2019). Nonetheless, issuers may apply the provisions of the final regulations to bonds sold before April 9, 2019.

Implications

The universally favorable comments on the proposed regulations and the decision by the IRS to publish the final regulations without any substantive changes indicate the need and desire for increased clarity by investors regarding investment-type property restrictions.

Although bond issuers have historically relied upon the legislative intent in the Preamble before its codification in the final regulations, the increase in surety provided by the final regulations is likely to reduce the cost and time issuers previously spent on compliance with these restrictions.

The final regulations do not remove, however, the need for arbitrage rebate analysis, nor do they change when and how the rebate is calculated. They also do not change any of the private business use rules related to tax-exempt bonds. All these factors 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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