[Code of Federal Regulations]
[Title 26, Volume 2]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.148-10]
[Page 710-715]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Sec. 1.148-10 Anti-abuse rules and authority of Commissioner.
(a) Abusive arbitrage device--(1) In general. Bonds of an issue are
arbitrage bonds under section 148 if an abusive arbitrage device under
paragraph (a)(2) of this section is used in connection with the issue.
This paragraph (a) is to be applied and interpreted broadly to carry out
the purposes of section 148, as further described in Sec. 1.148-0.
Except as otherwise provided in paragraph (c) of this section, any
action that is expressly permitted by section 148 or Secs. 1.148-1
through 1.148-11 is not an abusive arbitrage device (e.g., investment in
higher yielding investments during a permitted temporary period under
section 148(c)).
(2) Abusive arbitrage device defined. Any action is an abusive
arbitrage device if the action has the effect of--
(i) Enabling the issuer to exploit the difference between tax-exempt
and taxable interest rates to obtain a material financial advantage; and
(ii) Overburdening the tax-exempt bond market.
(3) Exploitation of tax-exempt interest rates. An action may exploit
tax-exempt interest rates under paragraph (a)(2) of this section as a
result of an investment of any portion of the gross
[[Page 711]]
proceeds of an issue over any period of time, notwithstanding that, in
the aggregate, the gross proceeds of the issue are not invested in
higher yielding investments over the term of the issue.
(4) Overburdening the tax-exempt market. An action overburdens the
tax-exempt bond market under paragraph (a)(2)(ii) of this section if it
results in issuing more bonds, issuing bonds earlier, or allowing bonds
to remain outstanding longer than is otherwise reasonably necessary to
accomplish the governmental purposes of the bonds, based on all the
facts and circumstances. Whether an action is reasonably necessary to
accomplish the governmental purposes of the bonds depends on whether the
primary purpose of the transaction is a bona fide governmental purpose
(e.g., an issue of refunding bonds to achieve a debt service
restructuring that would be issued independent of any arbitrage
benefit). An important factor bearing on this determination is whether
the action would reasonably be taken to accomplish the governmental
purpose of the issue if the interest on the issue were not excludable
from gross income under section 103(a) (assuming that the hypothetical
taxable interest rate would be the same as the actual tax-exempt
interest rate). Factors evidencing an overissuance include the issuance
of an issue the proceeds of which are reasonably expected to exceed by
more than a minor portion the amount necessary to accomplish the
governmental purposes of the issue, or an issue the proceeds of which
are, in fact, substantially in excess of the amount of sale proceeds
allocated to expenditures for the governmental purposes of the issue.
One factor evidencing an early issuance is the issuance of bonds that do
not qualify for a temporary period under Sec. 1.148-2(e)(2), (e)(3), or
(e)(4). One factor evidencing that bonds may remain outstanding longer
than necessary is a term that exceeds the safe harbors against the
creation of replacement proceeds under Sec. 1.148-1(c)(4)(i)(B). These
factors may be outweighed by other factors, however, such as bona fide
cost underruns or long-term financial distress.
(b) Consequences of overburdening the tax-exempt bond market--(1) In
general. An issue that overburdens the tax-exempt bond market (within
the meaning of paragraph (a)(4) of this section) is subject to the
following special limitations--
(i) Special yield restriction. Investments are subject to the
definition of materially higher yield under Sec. 1.148-2(d) that is
equal to one-thousandth of 1 percent. In addition, each investment is
treated as a separate class of investments under Sec. 1.148-5(b)(2)(ii),
the yield on which may not be blended with that of other investments.
(ii) Certain regulatory provisions inapplicable. The provisions of
Sec. 1.148-5(c) (relating to yield reduction payments) and Sec. 1.148-
5(e) (2) and (3) (relating to recovery of qualified administrative
costs) do not apply.
(iii) Restrictive expenditure rule. Proceeds are not allocated to
expenditures unless the proceeds-spent-last rule under Sec. 1.148-
6(d)(3)(i) is satisfied, applied by treating those proceeds as proceeds
to be used for restricted working capital expenditures. For this
purpose, available amount includes a reasonable working capital reserve
as defined in Sec. 1.148-6(d)(3)(iii)(B).
(2) Application. The provisions of this paragraph (b) only apply to
the portion of an issue that, as a result of actions taken (or actions
not taken) after the issue date, overburdens the market for tax-exempt
bonds, except that for an issue that is reasonably expected as of the
issue date to overburden the market, those provisions apply to all of
the gross proceeds of the issue.
(c) Anti-abuse rules on excess gross proceeds of advance refunding
issues--(1) In general. Except as otherwise provided in this paragraph
(c), an abusive arbitrage device is used and bonds of an advance
refunding issue are arbitrage bonds if the issue has excess gross
proceeds.
(2) Definition of excess gross proceeds. Excess gross proceeds means
all gross proceeds of an advance refunding issue that exceed an amount
equal to 1 percent of sale proceeds of the issue, other than gross
proceeds allocable to--
(i) Payment of principal, interest, or call premium on the prior
issue;
[[Page 712]]
(ii) Payment of pre-issuance accrued interest on the refunding
issue, and interest on the refunding issue that accrues for a period up
to the completion date of any capital project for which the prior issue
was issued, plus one year;
(iii) A reasonably required reserve or replacement fund for the
refunding issue or investment proceeds of such a fund;
(iv) Payment of costs of issuance of the refunding issue;
(v) Payment of administrative costs allocable to repaying the prior
issue, carrying and repaying the refunding issue, or investments of the
refunding issue;
(vi) Transferred proceeds that will be used or maintained for the
governmental purpose of the prior issue;
(vii) Interest on purpose investments;
(viii) Replacement proceeds in a sinking fund for the refunding
issue;
(ix) Qualified guarantee fees for the refunding issue or the prior
issue; and
(x) Fees for a qualified hedge for the refunding issue.
(3) Special treatment of transferred proceeds. For purposes of this
paragraph (c), all unspent proceeds of the prior issue as of the issue
date of the refunding issue are treated as transferred proceeds of the
advance refunding issue.
(4) Special rule for crossover refundings. An advance refunding
issue is not an issue of arbitrage bonds under this paragraph (c) if all
excess gross proceeds of the refunding issue are used to pay interest
that accrues on the refunding issue before the prior issue is
discharged, and no gross proceeds of any refunding issue are used to pay
interest on the prior issue or to replace funds used directly or
indirectly to pay such interest (other than transferred proceeds used to
pay interest on the prior issue that accrues for a period up to the
completion date of the project for which the prior issue was issued,
plus one year, or proceeds used to pay principal that is attributable to
accrued original issue discount).
(5) Special rule for gross refundings. This paragraph (c)(5) applies
if an advance refunding issue (the series B issue) is used together with
one or more other advance refunding issues (the series A issues) in a
gross refunding of a prior issue, but only if the use of a gross
refunding method is required under bond documents that were effective
prior to November 6, 1992. These advance refunding issues are not
arbitrage bonds under this paragraph (c) if--
(i) All excess gross proceeds of the series B issue and each series
A issue are investment proceeds used to pay principal and interest on
the series B issue;
(ii) At least 99 percent of all principal and interest on the series
B issue is paid with proceeds of the series B and series A issues or
with the earnings on other amounts in the refunding escrow for the prior
issue;
(iii) The series B issue is discharged not later than the prior
issue; and
(iv) As of any date, the amount of gross proceeds of the series B
issue allocated to expenditures does not exceed the aggregate amount of
expenditures before that date for principal and interest on the series B
issue, and administrative costs of carrying and repaying the series B
issue, or of investments of the series B issue.
(d) Examples. The provisions of this section are illustrated by the
following examples:
Example 1. Mortgage sale. In 1982, City issued its revenue issue
(the 1982 issue) and lent the proceeds to Developer to finance a low-
income housing project under former section 103(b)(4)(A) of the 1954
Code. In 1994, Developer encounters financial difficulties and
negotiates with City to refund the 1982 issue. City issues $10 million
in principal amount of its 8 percent bonds (the 1994 issue). City lends
the proceeds of the 1994 issue to Developer. To evidence Developer's
obligation to repay that loan, Developer, as obligor, issues a note to
City (the City note). Bank agrees to provide Developer with a direct-pay
letter of credit pursuant to which Bank will make all payments to the
trustee for the 1994 issue necessary to meet Developer's obligations
under the City note. Developer pays Bank a fee for the issuance of the
letter of credit and issues a note to Bank (the Bank note). The Bank
note is secured by a mortgage on the housing project and is guaranteed
by FHA. The Bank note and the 1994 issue have different prepayment
terms. The City does not reasonably expect to treat prepayments of the
Bank note as gross proceeds of the 1994 issue. At the same time or
pursuant to a series of related transactions, Bank sells the Bank note
to Investor for $9.5 million. Bank invests these monies together
[[Page 713]]
with its other funds. In substance, the transaction is a loan by City to
Bank, under which Bank enters into a series of transactions that, in
effect, result in Bank retaining $9.5 million in amounts treated as
proceeds of the 1994 issue. Those amounts are invested in materially
higher yielding investments that provide funds sufficient to equal or
exceed the Bank's liability under the letter of credit. Alternatively,
the letter of credit is investment property in a sinking fund for the
1994 issue provided by Developer, a substantial beneficiary of the
financing. Because, in substance, Developer acquires the $10 million
principal amount letter of credit for a fair market value purchase price
of $9.5 million, the letter of credit is a materially higher yielding
investment. Neither result would change if Developer's obligation under
the Bank note is contingent on Bank performing its obligation under the
letter of credit. Each characterization causes the bonds to be arbitrage
bonds.
Example 2. Bonds outstanding longer than necessary for yield-
blending device. (i) Longer bond maturity to create sinking fund. In
1994, Authority issues an advance refunding issue (the refunding issue)
to refund a 1982 prior issue (the prior issue). Under current market
conditions, Authority will have to invest the refunding escrow at a
yield significantly below the yield on the refunding issue. Authority
issues its refunding issue with a longer weighted average maturity than
otherwise necessary primarily for the purpose of creating a sinking fund
for the refunding issue that will be invested in a guaranteed investment
contract. The weighted average maturity of the refunding issue is less
than 120 percent of the remaining average economic life of the
facilities financed with the proceeds of the prior issue. The guaranteed
investment contract has a yield that is higher than the yield on the
refunding issue. The yield on the refunding escrow blended with the
yield on the guaranteed investment contract does not exceed the yield on
the issue. The refunding issue uses an abusive arbitrage device and the
bonds of the issue are arbitrage bonds under section 148(a).
(ii) Refunding of noncallable bonds. The facts are the same as in
paragraph (i) of this Example 2 except that instead of structuring the
refunding issue to enable it to take advantage of sinking fund
investments, Authority will also refund other long-term, non-callable
bonds in the same refunding issue. There are no savings attributable to
the refunding of the non-callable bonds (e.g., a low-to-high refunding).
The Authority invests the portion of the proceeds of the refunding issue
allocable to the refunding of the non-callable bonds in the refunding
escrow at a yield that is higher than the yield on the refunding issue,
based on the relatively long escrow period for this portion of the
refunding. The Authority invests the other portion of the proceeds of
the refunding issue in the refunding escrow at a yield lower than the
yield on the refunding issue. The blended yield on all the investments
in the refunding escrow for the prior issues does not exceed the yield
on the refunding issue. The portion of the refunding issue used to
refund the noncallable bonds, however, was not otherwise necessary and
was issued primarily to exploit the difference between taxable and tax-
exempt rates for that long portion of the refunding escrow to minimize
the effect of lower yielding investments in the other portion of the
escrow. The refunding issue uses an abusive arbitrage device and the
bonds of the issue are arbitrage bonds.
(iii) Governmental purpose. In paragraphs (i) and (ii) of this
Example 2, the existence of a governmental purpose for the described
financing structures would not change the conclusions unless Authority
clearly established that the primary purpose for the use of the
particular structure was a bona fide governmental purpose. The fact that
each financing structure had the effect of eliminating significant
amounts of negative arbitrage is strong evidence of a primary purpose
that is not a bona fide governmental purpose. Moreover, in paragraph (i)
of this Example 2, the structure of the refunding issue coupled with the
acquisition of the guaranteed investment contract to lock in the
investment yield associated with the structure is strong evidence of a
primary purpose that is not a bona fide governmental purpose.
Example 3. Window refunding. (i) Authority issues its 1994 refunding
issue to refund a portion of the principal and interest on its
outstanding 1985 issue. The 1994 refunding issue is structured using
zero-coupon bonds that pay no interest or principal for the 5-year
period following the issue date. The proceeds of the 1994 refunding
issue are deposited in a refunding escrow to be used to pay only the
interest requirements of the refunded portion of the 1985 issue.
Authority enters into a guaranteed investment contract with a financial
institution, G, under which G agrees to provide a guaranteed yield on
revenues invested by Authority during the 5-year period following the
issue date. The guaranteed investment contract has a yield that is no
higher than the yield on the refunding issue. The revenues to be
invested under this guaranteed investment contract consist of the
amounts that Authority otherwise would have used to pay principal and
interest on the 1994 refunding issue. The guaranteed investment contract
is structured to generate receipts at times and in amounts sufficient to
pay the principal and redemption requirements of the refunded portion of
the 1985 issue. A principal purpose of these transactions is to avoid
transferred proceeds. Authority will continue to invest the unspent
proceeds of the 1985 issue that are on deposit in a refunding escrow for
its 1982
[[Page 714]]
issue at a yield equal to the yield on the 1985 issue and will not
otherwise treat those unspent proceeds as transferred proceeds of the
1994 refunding issue. The 1994 refunding issue is an issue of arbitrage
bonds since those bonds involve a transaction or series of transactions
that overburdens the market by leaving bonds outstanding longer than is
necessary to obtain a material financial advantage based on arbitrage.
Specifically, Authority has structured the 1994 refunding issue to make
available for the refunding of the 1985 issue replacement proceeds
rather than proceeds so that the unspent proceeds of the 1985 issue will
not become transferred proceeds of the 1994 refunding issue.
(ii) The result would be the same in each of the following
circumstances:
(A) The facts are the same as in paragraph (i) of this Example 3
except that Authority does not enter into the guaranteed investment
contract but instead, as of the issue date of the 1994 refunding issue,
reasonably expects that the released revenues will be available for
investment until used to pay principal and interest on the 1985 issue.
(B) The facts are the same as in paragraph (i) of this Example 3
except that there are no unspent proceeds of the 1985 issue and
Authority invests the released revenues at a yield materially higher
than the yield on the 1994 issue.
(C) The facts are the same as in paragraph (i) of this Example 3
except that Authority uses the proceeds of the 1994 issue for capital
projects instead of to refund a portion of the 1985 issue.
Example 4. Sale of conduit loan. On January 1, 1994, Authority
issues a conduit financing issue (the 1994 conduit financing issue) and
uses the proceeds to purchase from City, an unrelated party, a tax-
exempt bond of City (the City note). The proceeds of the 1994 conduit
financing issue are to be used to advance refund a prior conduit
financing issue that was issued in 1988 and used to make a loan to City.
The 1994 conduit financing issue and the City note each have a yield of
8 percent on January 1, 1994. On June 30, 1996, interest rates have
decreased and Authority sells the City note to D, a person unrelated to
either City or Authority. Based on the sale price of the City note and
treating June 30, 1996 as the issue date of the City note, the City note
has a 6 percent yield. Authority deposits the proceeds of the sale of
the City note into an escrow to redeem the bonds of the 1994 conduit
financing issue on January 1, 2001. The escrow is invested in nonpurpose
investments having a yield of 8 percent. For purposes of section 149(d),
City and Authority are related parties and, therefore, the issue date of
the City note is treated as being June 30, 1996. Thus, the City note is
an advance refunding of Authority's 1994 conduit financing issue.
Interest on the City note is not exempt from Federal income tax from the
date it is sold to D under section 149(d), because, by investing the
escrow investments at a yield of 8 percent instead of a yield not
materially higher than 6 percent, the sale of the City note employs a
device to obtain a material financial advantage, based on arbitrage,
apart from the savings attributable to lower interest rates. In
addition, the City note is not a tax-exempt bond because the note is the
second advance refunding of the original bond under section 149(d)(3).
The City note also employs an abusive arbitrage device and is an
arbitrage bond under section 148.
Example 5. Re-refunding. (i) On January 1, 1984, City issues a tax-
exempt issue (the 1984 issue) to finance the cost of constructing a
prison. The 1984 issue has a 7 percent yield and a 30-year maturity. The
1984 issue is callable at any time on or after January 1, 1994. On
January 1, 1990, City issues a refunding issue (the 1990 issue) to
advance refund the 1984 issue. The 1990 issue has an 8 percent yield and
a 30-year maturity. The 1990 issue is callable at any time on or after
January 1, 2000. The proceeds of the 1990 issue are invested at an 8
percent yield in a refunding escrow for the 1984 issue (the original
1984 escrow) in a manner sufficient to pay debt service on the 1984
issue until maturity (i.e., an escrow to maturity). On January 1, 1994,
City issues a refunding issue (the 1994 issue). The 1994 issue has a 6
percent yield and a 30-year maturity. City does not invest the proceeds
of the 1994 issue in a refunding escrow for the 1990 issue in a manner
sufficient to pay a portion of the debt service until, and redeem a
portion of that issue on, January 1, 2000. Instead, City invests those
proceeds at a 6 percent yield in a new refunding escrow for a portion of
the 1984 issue (the new 1984 escrow) in a manner sufficient to pay debt
service on a portion of the 1984 issue until maturity. City also
liquidates the investments allocable to the proceeds of the 1990 issue
held in the original 1984 escrow and reinvests those proceeds in an
escrow to pay a portion of the debt service on the 1990 issue itself
until, and redeem a portion of that issue on, January 1, 2000 (the 1990
escrow). The 1994 bonds are arbitrage bonds and employ an abusive device
under section 149(d)(4). Although, in form, the proceeds of the 1994
issue are used to pay principal on the 1984 issue, this accounting for
the use of the proceeds of the 1994 issue is an unreasonable,
inconsistent accounting method under Sec. 1.148-6(a). Moreover, since
the proceeds of the 1990 issue were set aside in an escrow to be used to
retire the 1984 issue, the use of proceeds of the 1994 issue for that
same purpose involves a replacement of funds invested in higher yielding
investments under section 148(a)(2). Thus, using a reasonable,
consistent accounting method and giving effect to the substance of the
transaction, the proceeds of the 1994 issue are treated as used to
refund the 1990 issue
[[Page 715]]
and are allocable to the 1990 escrow. The proceeds of the 1990 issue are
treated as used to refund the 1984 issue and are allocable to the
investments in the new 1984 escrow. The proceeds of the 1990 issue
allocable to the nonpurpose investments in the new 1984 escrow become
transferred proceeds of the 1994 issue as principal is paid on the 1990
issue from amounts on deposit in the 1990 escrow. As a result, the yield
on nonpurpose investments allocable to the 1994 issue is materially
higher than the yield on the 1994 issue, causing the bonds of the 1994
issue to be arbitrage bonds. In addition, the transaction employs a
device under section 149(d)(4) to obtain a material financial advantage
based on arbitrage, other than savings attributable to lower interest
rates.
(ii) The following changes in the facts do not affect the conclusion
that the 1994 issue consists of arbitrage bonds--
(1) The 1990 issue is a taxable issue;
(2) The original 1984 escrow is used to pay the 1994 issue (rather
than the 1990 issue); or
(3) The 1994 issue is used to retire the 1984 issue within 90 days
of January 1, 1994.
(e) Authority of the Commissioner to clearly reflect the economic
substance of a transaction. If 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
that is inconsistent with the purposes of section 148, the Commissioner
may exercise the Commissioner's discretion to depart from the rules of
Sec. 1.148-1 through Sec. 1.148-11 as necessary to clearly reflect the
economic substance of the transaction. For this purpose, the
Commissioner may recompute yield on an issue or on investments,
reallocate payments and receipts on investments, recompute the rebate
amount on an issue, treat a hedge as either a qualified hedge or not a
qualified hedge, or otherwise adjust any item whatsoever bearing upon
the investments and expenditures of gross proceeds of an issue. For
example, if the amount paid for a hedge is specifically based on the
amount of arbitrage earned or expected to be earned on the hedged bonds,
a principal purpose of entering into the contract is to obtain a
material financial advantage based on the difference between tax-exempt
and taxable interest rates in a manner that is inconsistent with the
purposes of section 148.
(f) Authority of the Commissioner to require an earlier date for
payment of rebate. If the Commissioner determines that an issue is
likely to fail to meet the requirements of Sec. 1.148-3 and that a
failure to serve a notice of demand for payment on the issuer will
jeopardize the assessment or collection of tax on interest paid or to be
paid on the issue, the date that the Commissioner serves notice on the
issuer is treated as a required computation date for payment of rebate
for that issue.
(g) Authority of the Commissioner to waive regulatory limitations.
Notwithstanding any specific provision in Secs. 1.148-1 through 1.148-
11, the Commissioner may prescribe extensions of temporary periods,
larger reasonably required reserve or replacement funds, or consequences
of failures or remedial action under section 148 in lieu of or in
addition to other consequences of those failures, or take other action,
if the Commissioner finds that good faith or other similar circumstances
so warrant, consistent with the purposes of section 148.
[T.D. 8476, 58 FR 33544, June 18, 1993; 58 FR 44453, Aug. 23, 1993, as
amended by T.D. 8538, 59 FR 24046, May 10, 1994; T.D. 8476, 59 FR 24351,
May 11, 1994; T.D. 8718, 62 FR 25512, May 9, 1997]