[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: 26CFR1.148-2]
[Page 663-667]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Sec. 1.148-2 General arbitrage yield restriction rules.
(a) In general. Under section 148(a), the direct or indirect
investment of the gross proceeds of an issue in higher yielding
investments causes the bonds of the issue to be arbitrage bonds. The
investment of proceeds in higher yielding investments, however, during a
temporary period described in paragraph (e) of this section, as part of
a reasonably required reserve or replacement fund described in paragraph
(f) of this section, or as part of a minor portion described in
paragraph (g) of this section does not cause the bonds of the issue to
be arbitrage bonds. Bonds are not arbitrage bonds under this section as
a result of an inadvertent, insubstantial error.
(b) Reasonable expectations--(1) In general. Except as provided in
paragraph (c) of this section, the determination of whether an issue
consists of arbitrage bonds under section 148(a) is based on the
issuer's reasonable expectations as of the issue date regarding the
amount and use of the gross proceeds of the issue.
(2) Certification of expectations--(i) In general. An officer of the
issuer responsible for issuing the bonds must, in good faith, certify
the issuer's expectations as of the issue date. The certification must
state the facts and estimates that form the basis for the issuer's
expectations. The certification is evidence of the issuer's
expectations, but does not establish any conclusions of law or any
presumptions regarding either the issuer's actual expectations or their
reasonableness.
(ii) Exceptions to certification requirement. An issuer is not
required to make
[[Page 664]]
a certification for an issue under paragraph (b)(2)(i) of this section
if--
(A) The issuer reasonably expects as of the issue date that there
will be no unspent gross proceeds after the issue date, other than gross
proceeds in a bona fide debt service fund (e.g., equipment lease
financings in which the issuer purchases equipment in exchange for an
installment payment note); or
(B) The issue price of the issue does not exceed $1,000,000.
(c) Intentional acts. The taking of any deliberate, intentional
action by the issuer or person acting on its behalf after the issue date
in order to earn arbitrage causes the bonds of the issue to be arbitrage
bonds if that action, had it been expected on the issue date, would have
caused the bonds to be arbitrage bonds. An intent to violate the
requirements of section 148 is not necessary for an action to be
intentional.
(d) Materially higher yielding investments--(1) In general. The
yield on investments is materially higher than the yield on the issue to
which the investments are allocated if the yield on the investments over
the term of the issue exceeds the yield on the issue by an amount in
excess of the applicable definition of materially higher set forth in
paragraph (d)(2) of this section. If yield restricted investments in the
same class are subject to different definitions of materially higher,
the applicable definition of materially higher that produces the lowest
permitted yield applies to all the investments in the class. The yield
on the issue is determined under Sec. 1.148-4. The yield on investments
is determined under Sec. 1.148-5.
(2) Definitions of materially higher yield--(i) General rule for
purpose and nonpurpose investments. For investments that are not
otherwise described in this paragraph (d)(2), materially higher means
one-eighth of 1 percentage point.
(ii) Refunding escrows and replacement proceeds. For investments in
a refunding escrow or for investments allocable to replacement proceeds,
materially higher means one-thousandth of 1 percentage point.
(iii) Program investments. For program investments that are not
described in paragraph (d)(2)(iv) of this section, materially higher
means 1 and one-half percentage points.
(iv) Student loans. For qualified student loans that are program
investments, materially higher means 2 percentage points.
(v) Tax-exempt investments. For investments that are tax-exempt
bonds and are not investment property under section 148(b)(3), no yield
limitation applies.
(3) Mortgage loans. Qualified mortgage loans that satisfy the
requirements of section 143(g) are treated as meeting the requirements
of this paragraph (d).
(e) Temporary periods--(1) In general. During the temporary periods
set forth in this paragraph (e), the proceeds and replacement proceeds
of an issue may be invested in higher yielding investments without
causing bonds in the issue to be arbitrage bonds. This paragraph (e)
does not apply to refunding issues (see Sec. 1.148-9).
(2) General 3-year temporary period for capital projects and
qualified mortgage loans--(i) In general. The net sale proceeds and
investment proceeds of an issue reasonably expected to be allocated to
expenditures for capital projects qualify for a temporary period of 3
years beginning on the issue date (the 3-year temporary period). The 3-
year temporary period also applies to the proceeds of qualified mortgage
bonds and qualified veterans' mortgage bonds by substituting qualified
mortgage loans in each place that capital projects appears in this
paragraph (e)(2). The 3-year temporary period applies only if the issuer
reasonably expects to satisfy the expenditure test, the time test, and
the due diligence test. These rules apply separately to each conduit
loan financed by an issue (other than qualified mortgage loans), with
the expenditure and time tests measured from the issue date of the
issue.
(A) Expenditure test. The expenditure test is met if at least 85
percent of the net sale proceeds of the issue are allocated to
expenditures on the capital projects by the end of the 3-year temporary
period.
(B) Time test. The time test is met if the issuer incurs within 6
months of the issue date a substantial binding obligation to a third
party to expend at
[[Page 665]]
least 5 percent of the net sale proceeds of the issue on the capital
projects. An obligation is not binding if it is subject to contingencies
within the issuer's or a related party's control.
(C) Due diligence test. The due diligence test is met if completion
of the capital projects and the allocation of the net sale proceeds of
the issue to expenditures proceed with due diligence.
(ii) 5-year temporary period. In the case of proceeds expected to be
allocated to a capital project involving a substantial amount of
construction expenditures (as defined in Sec. 1.148-7), a 5-year
temporary period applies in lieu of the 3-year temporary period if the
issuer satisfies the requirements of paragraph (e)(2)(i) of this section
applied by substituting ``5 years'' in each place that ``3 years''
appears, and both the issuer and a licensed architect or engineer
certify that the longer period is necessary to complete the capital
project.
(3) Temporary period for restricted working capital expenditures--
(i) General rule. The proceeds of an issue that are reasonably expected
to be allocated to restricted working capital expenditures within 13
months after the issue date qualify for a temporary period of 13 months
beginning on the issue date. Paragraph (e)(2) of this section contains
additional temporary period rules for certain working capital
expenditures that are treated as part of a capital project.
(ii) Longer temporary period for certain tax anticipation issues. If
an issuer reasonably expects to use tax revenues arising from tax levies
for a single fiscal year to redeem or retire an issue, and the issue
matures by the earlier of 2 years after the issue date or 60 days after
the last date for payment of those taxes without interest or penalty,
the temporary period under paragraph (e)(3)(i) of this section is
extended until the maturity date of the issue.
(4) Temporary period for pooled financings--(i) In general. Proceeds
of a pooled financing issue reasonably expected to be used to finance
purpose investments qualify for a temporary period of 6 months while
held by the issuer before being loaned to a conduit borrower. Any
otherwise available temporary period for proceeds held by a conduit
borrower, however, is reduced by the period of time during which those
proceeds were held by the issuer before being loaned. For example, if
the proceeds of a pooled financing issue loaned to a conduit borrower
would qualify for a 3-year temporary period, and the proceeds are held
by the issuer for 5 months before being loaned to the conduit borrower,
the proceeds qualify for only an additional 31-month temporary period
after being loaned to the conduit borrower. Except as provided in
paragraph (e)(4)(iv) of this section, this paragraph (e)(4) does not
apply to any qualified mortgage bond or qualified veterans' mortgage
bond under section 143.
(ii) Loan repayments--(A) Amount held by the issuer. The temporary
period under this paragraph (e)(4) for proceeds from the sale or
repayment of any loan that are reasonably expected to be used to make or
finance new loans is 3 months.
(B) Amounts re-loaned to conduit borrowers. Any temporary period for
proceeds held by a conduit borrower under a new loan from amounts
described in paragraph (e)(4)(ii)(A) of this section is determined by
treating the date the new loan is made as the issue date and by reducing
the temporary period by the period the amounts were held by the issuer
following the last repayment.
(iii) Construction issues. If all or a portion of a pooled financing
issue qualifies as a construction issue under Sec. 1.148-7(b)(6),
paragraph (e)(4)(i) of this section is applied by substituting ``2
years'' for ``6 months.''
(iv) Amounts re-loaned for qualified mortgage loans. The temporary
period under this paragraph (e)(4) for proceeds from the sale,
prepayment, or repayment of any qualified mortgage loan that are
reasonably expected to be used to make or finance new qualified mortgage
loans is 3 years.
(5) Temporary period for replacement proceeds--(i) In general.
Except as otherwise provided, replacement proceeds qualify for a
temporary period of 30 days beginning on the date that the amounts are
first treated as replacement proceeds.
(ii) Temporary period for bona fide debt service funds. Amounts in a
bona fide
[[Page 666]]
debt service fund for an issue qualify for a temporary period of 13
months. If only a portion of a fund qualifies as a bona fide debt
service fund, only that portion qualifies for this temporary period.
(6) Temporary period for investment proceeds. Except as otherwise
provided in this paragraph (e), investment proceeds qualify for a
temporary period of 1 year beginning on the date of receipt.
(7) Other amounts. Gross proceeds not otherwise eligible for a
temporary period described in this paragraph (e) qualify for a temporary
period of 30 days beginning on the date of receipt.
(f) Reserve or replacement funds--(1) General 10 percent limitation
on funding with sale proceeds. An issue consists of arbitrage bonds if
sale proceeds of the issue in excess of 10 percent of the stated
principal amount of the issue are used to finance any reserve or
replacement fund, without regard to whether those sale proceeds are
invested in higher yielding investments. If an issue has more than a de
minimis amount of original issue discount or premium, the issue price
(net of pre-issuance accrued interest) is used to measure the 10-percent
limitation in lieu of stated principal amount. This rule does not limit
the use of amounts other than sale proceeds of an issue to fund a
reserve or replacement fund.
(2) Exception from yield restriction for reasonably required reserve
or replacement funds--(i) In general. The investment of amounts that are
part of a reasonably required reserve or replacement fund in higher
yielding investments will not cause an issue to consist of arbitrage
bonds. A reasonably required reserve or replacement fund may consist of
all or a portion of one or more funds, however labelled, derived from
one or more sources. Amounts in a reserve or replacement fund in excess
of the amount that is reasonably required are not part of a reasonably
required reserve or replacement fund.
(ii) Size limitation. The amount of gross proceeds of an issue that
qualifies as a reasonably required reserve or replacement fund may not
exceed an amount equal to the least of 10 percent of the stated
principal amount of the issue, the maximum annual principal and interest
requirements on the issue, or 125 percent of the average annual
principal and interest requirements on the issue. If an issue has more
than a de minimis amount of original issue discount or premium, the
issue price of the issue (net of pre-issuance accrued interest) is used
to measure the 10 percent limitation in lieu of its stated principal
amount. For a reserve or replacement fund that secures more than one
issue (e.g. a parity reserve fund), the size limitation may be measured
on an aggregate basis.
(iii) Valuation of investments. Investments in a reasonably required
reserve or replacement fund may be valued in any reasonable,
consistently applied manner that is permitted under Sec. 1.148-5.
(iv) 150 percent debt service limitation on investment in nonpurpose
investments for certain private activity bonds. Section 148(d)(3)
contains additional limits on the amount of gross proceeds of an issue
of private activity bonds, other than qualified 501(c)(3) bonds, that
may be invested in higher yielding nonpurpose investments without
causing the bonds to be arbitrage bonds. For purposes of these rules,
initial temporary period means the temporary periods under paragraphs
(e)(2), (e)(3), and (e)(4) of this section and under Sec. 1.148-
9(d)(2)(i), (ii), and (iii).
(3) Certain parity reserve funds. The limitation contained in
paragraph (f)(1) of this section does not apply to an issue if the
master legal document authorizing the issuance of the bonds (e.g., a
master indenture) was adopted before August 16, 1986, and that document-
-
(i) Requires a reserve or replacement fund in excess of 10 percent
of the sale proceeds, but not more than maximum annual principal and
interest requirements;
(ii) Is not amended after August 31, 1986 (other than to permit the
issuance of additional bonds as contemplated in the master legal
document); and
(iii) Provides that bonds having a parity of security may not be
issued by or on behalf of the issuer for the purposes provided under the
document without satisfying the reserve fund requirements of the
indenture.
[[Page 667]]
(g) Minor portion. Under section 148(e), a bond of an issue is not
an arbitrage bond solely because of the investment in higher yielding
investments of gross proceeds of the issue in an amount not exceeding
the lesser of--
(1) 5 percent of the sale proceeds of the issue; or
(2) $100,000.
(h) Certain waivers permitted. On or before the issue date, an
issuer may elect to waive the right to invest in higher yielding
investments during any temporary period under paragraph (e) of this
section or as part of a reasonably required reserve or replacement fund
under paragraph (f) of this section. At any time, an issuer may waive
the right to invest in higher yielding investments as part of a minor
portion under paragraph (g) of this section.
[T.D. 8476, 58 FR 33520, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507,
May 9, 1997]