[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: 26CFR1.148-7]
[Page 695-703]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Sec. 1.148-7 Spending exceptions to the rebate requirement.
(a) Scope of section--(1) In general. This section provides guidance
on the spending exceptions to the arbitrage rebate requirement of
section 148(f)(2). These exceptions are the 6-month exception in section
148(f)(4)(B) (the 6-month exception), the 18-month exception under
paragraph (d) of this section (the 18-month exception), and the 2-year
construction exception under section 148(f)(4)(C) (the 2-year exception)
(collectively, the spending exceptions).
(2) Relationship of spending exceptions. Each of the spending
exceptions is an independent exception to arbitrage rebate. For example,
a construction issue may qualify for the 6-month exception or the 18-
month exception even though the issuer makes one or more elections under
the 2-year exception with respect to the issue.
(3) Spending exceptions not mandatory. Use of the spending
exceptions is not mandatory. An issuer may apply the arbitrage rebate
requirement to an issue that otherwise satisfies a spending exception.
If an issuer elects to pay penalty in lieu of rebate under the 2-year
exception, however, the issuer must apply those penalty provisions.
(b) Rules applicable for all spending exceptions. The provisions of
this paragraph (b) apply for purposes of applying each of the spending
exceptions.
(1) Special transferred proceeds rules--(i) Application to prior
issues. For purposes of applying the spending exceptions to a prior
issue only, proceeds of the prior issue that become transferred proceeds
of the refunding issue continue to be treated as unspent proceeds of the
prior issue. If the prior issue satisfies one of the spending
exceptions, the proceeds of the prior issue that are excepted from
rebate under that spending exception are not subject to rebate either as
proceeds of the prior issue or as transferred proceeds of the refunding
issue.
(ii) Application to refunding issues--(A) In general. The only
spending exception applicable to refunding issues is the 6-month
exception. For purposes of applying the 6-month exception to a refunding
issue only, proceeds of the prior issue that become transferred proceeds
of the refunding issue generally are not treated as proceeds of the
refunding issue and need not be spent for the refunding issue to satisfy
that spending exception. Even if the refunding issue qualifies for that
spending exception, those transferred proceeds are subject to rebate as
proceeds of the refunding issue unless an exception to rebate applied to
those proceeds as proceeds of the prior issue.
(B) Exception. For purposes of applying the 6-month exception to
refunding issues, those transferred proceeds of the refunding issue
excluded from the gross proceeds of the prior issue under the special
definition of gross proceeds in paragraph (c)(3) of this section, and
those that transferred from a prior taxable issue, are generally treated
as gross proceeds of the refunding issue. Thus, for the refunding issue
to qualify for the 6-month exception, those proceeds must be spent
within 6 months of the issue date of the refunding issue, unless those
amounts continue to be used in a manner that does not cause those
amounts to be gross proceeds under paragraph (c)(3) of this section.
(2) Application of multipurpose issue rules. Except as otherwise
provided, if any portion of an issue is treated as a separate issue
allocable to refunding purposes under Sec. 1.148-9(h) (relating to
multipurpose issues), for purposes of this section, that portion is
treated as a separate issue.
[[Page 696]]
(3) Expenditures for governmental purposes of the issue. For
purposes of this section, expenditures for the governmental purpose of
an issue include payments for interest, but not principal, on the issue,
and for principal or interest on another issue of obligations. The
preceding sentence does not apply for purposes of the 18-month and 2-
year exceptions if those payments cause the issue to be a refunding
issue.
(4) De minimis rule. Any failure to satisfy the final spending
requirement of the 18-month exception or the 2-year exception is
disregarded if the issuer exercises due diligence to complete the
project financed and the amount of the failure does not exceed the
lesser of 3 percent of the issue price of the issue or $250,000.
(5) Special definition of reasonably required reserve or replacement
fund. For purposes of this section only, a reasonably required reserve
or replacement fund also includes any fund to the extent described in
Sec. 1.148-5(c)(3)(i)(E) or (G).
(6) Pooled financing issue--(i) In general. Except as otherwise
provided in this paragraph (b)(6), the spending exceptions apply to a
pooled financing issue as a whole, rather than to each loan separately.
(ii) Election to apply spending exceptions separately to each loan--
(A) In general. At the election (made on or before the issue date) of
the issuer of a pooled financing issue, the spending exceptions are
applied separately to each conduit loan, and the applicable spending
requirements for a loan begin on the earlier of the date the loan is
made, or the first day following the 1-year period beginning on the
issue date of the pooled financing issue. If this election is made, the
rebate requirement applies to, and none of the spending exceptions are
available for, gross proceeds of the pooled financing bonds before the
date on which the spending requirements for those proceeds begin.
(B) Application of spending exceptions. If the issuer makes the
election under this paragraph (b)(6)(ii), the rebate requirement is
satisfied for proceeds used to finance a particular conduit loan to the
extent that the loan satisfies a spending exception or the small issuer
exception under Sec. 1.148-8, regardless of whether any other conduit
loans allocable to the issue satisfy such an exception. A pooled
financing issue is an issue of arbitrage bonds, however, unless the
entire issue satisfies the requirements of section 148. An issuer may
pay rebate for some conduit loans and 1\1/2\ percent penalty for other
conduit loans from the same pooled financing issue. The 1\1/2\ percent
penalty is computed separately for each conduit loan.
(C) Elections under 2-year exception. If the issuer makes the
election under this paragraph (b)(6)(ii), the issuer may make all
elections under the 2-year exception separately for each loan. Elections
regarding a loan that otherwise must be made by the issuer on or before
the issue date instead may be made on or before the date the loan is
made (but not later than 1 year after the issue date).
(D) Example. The operation of this paragraph (b)(6) is illustrated
by the following example:
Example. Pooled financing issue. On January 1, 1994, Authority J
issues bonds. As of the issue date, J reasonably expects to use the
proceeds of the issue to make loans to City K, County L, and City M. J
does not reasonably expect to use more than 75 percent of the available
construction proceeds of the issue for construction expenditures. On or
before the issue date, J elects to apply the spending exceptions
separately for each loan, with spending requirements beginning on the
earlier of the date the loan is made or the first day following the 1-
year period beginning on the issue date. On February 1, 1994, J loans a
portion of the proceeds to K, and K reasonably expects that 45 percent
of those amounts will be used for construction expenditures. On the date
this loan is made, J elects under paragraph (j) of this section to treat
60 percent of the amount loaned to K as a separate construction issue,
and also elects the 1\1/2\ percent penalty under paragraph (k) of this
section for the separate construction issue. On March 1, 1994, J loans a
portion of the proceeds to L, and L reasonably expects that more than 75
percent of those amounts will be used for construction expenditures. On
March 1, 1995, J loans the remainder of the proceeds to M, and none of
those amounts will be used for construction expenditures. J must satisfy
the rebate requirement for all gross proceeds before those amounts are
loaned. For the loan to K, the spending periods begin on February 1,
1994, and the 1\1/2\ percent penalty must be paid for any failure to
meet a spending requirement
[[Page 697]]
for the portion of the loan to K that is treated as a separate
construction issue. Rebate must be paid on the remaining portion of the
loan to K, unless that portion qualifies for the 6-month exception. For
the loan to L, the spending periods begin on March 1, 1994, and the
rebate requirement must be satisfied unless the 6-month, 18-month, or
the 2-year exception is satisfied with respect to those amounts. For the
loan to M, the spending periods begin on January 2, 1995, and the rebate
requirement must be satisfied for those amounts unless the 6-month or
18-month exception is satisfied.
(c) 6-month exception-- (1)General rule. An issue is treated as
meeting the rebate requirement if--
(i) The gross proceeds (as modified by paragraph (c)(3) of this
section) of the issue are allocated to expenditures for the governmental
purposes of the issue within the 6-month period beginning on the issue
date (the 6-month spending period); and
(ii) The rebate requirement is met for amounts not required to be
spent within the 6-month spending period (excluding earnings on a bona
fide debt service fund).
(2) Additional period for certain bonds. The 6-month spending period
is extended for an additional 6 months in certain circumstances
specified under section 148(f)(4)(B)(ii).
(3) Amounts not included in gross proceeds. For purposes of
paragraph (c)(1)(i) of this section only, gross proceeds has the meaning
used in Sec. 1.148-1, except it does not include amounts--
(i) In a bona fide debt service fund;
(ii) In a reasonably required reserve or replacement fund (see
Sec. 1.148-7(b)(5));
(iii) That, as of the issue date, are not reasonably expected to be
gross proceeds but that become gross proceeds after the end of the 6-
month spending period;
(iv) Representing sale or investment proceeds derived from payments
under any purpose investment of the issue; and
(v) Representing repayments of grants (as defined in Sec. 1.148-
6(d)(4)) financed by the issue.
(4) Series of refundings. If a principal purpose of a series of
refunding issues is to exploit the difference between taxable and tax-
exempt interest rates by investing proceeds during the temporary periods
provided in Sec. 1.148-9(d), the 6-month spending period for all issues
in the series begins on the issue date of the first issue in the series.
(d) 18-month exception--(1) General rule. An issue is treated as
meeting the rebate requirement if all of the following requirements are
satisfied--
(i) 18-month expenditure schedule met. The gross proceeds (as
defined in paragraph (d)(3) of this section) are allocated to
expenditures for a governmental purpose of the issue in accordance with
the following schedule (the 18-month expenditure schedule) measured from
the issue date--
(A) At least 15 percent within 6 months (the first spending period);
(B) At least 60 percent within 12 months (the second spending
period); and
(C) 100 percent within 18 months (the third spending period).
(ii) Rebate requirement met for amounts not required to be spent.
The rebate requirement is met for all amounts not required to be spent
in accordance with the 18-month expenditure schedule (other than
earnings on a bona fide debt service fund).
(iii) Issue qualifies for initial temporary period. All of the gross
proceeds (as defined in paragraph (d)(3)(i) of this section) of the
issue qualify for the initial temporary period under Sec. 1.148-2(e)(2).
(2) Extension for reasonable retainage. An issue does not fail to
satisfy the spending requirement for the third spending period as a
result of a reasonable retainage if the reasonable retainage is
allocated to expenditures within 30 months of the issue date. Reasonable
retainage has the meaning under paragraph (h) of this section, as
modified to refer to net sale proceeds on the date 18 months after the
issue date.
(3) Gross proceeds--(i) Definition of gross proceeds. For purposes
of paragraph (d)(1) of this section only, gross proceeds means gross
proceeds as defined in paragraph (c)(3) of this section, as modified to
refer to ``18 months'' in paragraph (c)(3)(iii) of this section in lieu
of ``6 months.''
(ii) Estimated earnings. For purposes of determining compliance with
the first two spending periods under paragraph (d)(1)(i) of this
section, the
[[Page 698]]
amount of investment proceeds included in gross proceeds of the issue is
determined based on the issuer's reasonable expectations on the issue
date.
(4) Application to multipurpose issues. This paragraph (d) does not
apply to an issue any portion of which is treated as meeting the rebate
requirement under paragraph (e) of this section (relating to the 2-year
exception).
(e) 2-year exception--(1) General rule. A construction issue is
treated as meeting the rebate requirement for available construction
proceeds if those proceeds are allocated to expenditures for
governmental purposes of the issue in accordance with the following
schedule (the 2-year expenditure schedule), measured from the issue
date--
(i) At least 10 percent within 6 months (the first spending period);
(ii) At least 45 percent within 1 year (the second spending period);
(iii) At least 75 percent within 18 months (the third spending
period); and
(iv) 100 percent within 2 years (the fourth spending period).
(2) Extension for reasonable retainage. An issue does not fail to
satisfy the spending requirement for the fourth spending period as a
result of unspent amounts for reasonable retainage (as defined in
paragraph (h) of this section) if those amounts are allocated to
expenditures within 3 years of the issue date.
(3) Definitions. For purposes of the 2-year exception, the following
definitions apply:
(i) Real property means land and improvements to land, such as
buildings or other inherently permanent structures, including interests
in real property. For example, real property includes wiring in a
building, plumbing systems, central heating or air-conditioning systems,
pipes or ducts, elevators, escalators installed in a building, paved
parking areas, roads, wharves and docks, bridges, and sewage lines.
(ii) Tangible personal property means any tangible property other
than real property, including interests in tangible personal property.
For example, tangible personal property includes machinery that is not a
structural component of a building, subway cars, fire trucks,
automobiles, office equipment, testing equipment, and furnishings.
(iii) Substantially completed. Construction may be treated as
substantially completed when the issuer abandons construction or when at
least 90 percent of the total costs of the construction reasonably
expected, as of that date, to be financed with the available
construction proceeds have been allocated to expenditures.
(f) Construction issue--(1) Definition. Construction issue means any
issue that is not a refunding issue if--
(i) The issuer reasonably expects, as of the issue date, that at
least 75 percent of the available construction proceeds of the issue
will be allocated to construction expenditures (as defined in paragraph
(g) of this section) for property owned by a governmental unit or a
501(c)(3) organization; and
(ii) Any private activity bonds that are part of the issue are
qualified 501(c)(3) bonds or private activity bonds issued to finance
property to be owned by a governmental unit or a 501(c)(3) organization.
(2) Use of actual facts. For the provisions of paragraphs (e)
through (m) of this section that apply based on the issuer's reasonable
expectations, an issuer may elect on or before the issue date to apply
all of those provisions based on actual facts, except that this election
does not apply for purposes of determining whether an issue is a
construction issue under paragraph (f)(1) of this section if the 1\1/2\
percent penalty election is made under paragraph (k) of this section.
(3) Ownership requirement--(i) In general. A governmental unit or
501(c)(3) organization is treated as the owner of property if it would
be treated as the owner for Federal income tax purposes. For obligations
issued on behalf of a State or local governmental unit, the entity that
actually issues the bonds is treated as a governmental unit.
(ii) Safe harbor for leases and management contracts. Property
leased by a governmental unit or a 501(c)(3) organization is treated as
owned by the governmental unit or 501(c)(3) organization if the lessee
complies with the requirements of section 142(b)(1)(B). For a bond
described in section 142(a)(6), the
[[Page 699]]
requirements of section 142(b)(1)(B) apply as modified by section
146(h)(2).
(g) Construction expenditures--(1) Definition. Except as otherwise
provided, construction expenditures means capital expenditures (as
defined in Sec. 1.150-1) that are allocable to the cost of real property
or constructed personal property (as defined in paragraph (g)(3) of this
section). Except as provided in paragraph (g)(2) of this section,
construction expenditures do not include expenditures for acquisitions
of interests in land or other existing real property.
(2) Certain acquisitions under turnkey contracts treated as
construction expenditures. Expenditures are not for the acquisition of
an interest in existing real property other than land if the contract
between the seller and the issuer requires the seller to build or
install the property (e.g., a turnkey contract), but only to the extent
that the property has not been built or installed at the time the
parties enter into the contract.
(3) Constructed personal property. Constructed personal property
means tangible personal property (or, if acquired pursuant to a single
acquisition contract, properties) or specially developed computer
software if--
(i) A substantial portion of the property or properties is completed
more than 6 months after the earlier of the date construction or
rehabilitation commenced and the date the issuer entered into an
acquisition contract;
(ii) Based on the reasonable expectations of the issuer, if any, or
representations of the person constructing the property, with the
exercise of due diligence, completion of construction or rehabilitation
(and delivery to the issuer) could not have occurred within that 6-month
period; and
(iii) If the issuer itself builds or rehabilitates the property, not
more than 75 percent of the capitalizable cost is attributable to
property acquired by the issuer (e.g., components, raw materials, and
other supplies).
(4) Specially developed computer software. Specially developed
computer software means any programs or routines used to cause a
computer to perform a desired task or set of tasks, and the
documentation required to describe and maintain those programs, provided
that the software is specially developed and is functionally related and
subordinate to real property or other constructed personal property.
(5) Examples. The operation of this paragraph (g) is illustrated by
the following examples:
Example 1. Purchase of construction materials. City A issues bonds
to finance a new office building. A uses proceeds of the bonds to
purchase materials to be used in constructing the building, such as
bricks, pipes, wires, lighting, carpeting, heating equipment, and
similar materials. Expenditures by A for the construction materials are
construction expenditures because those expenditures will be
capitalizable to the cost of the building upon completion, even though
they are not initially capitalizable to the cost of existing real
property. This result would be the same if A hires a third-party to
perform the construction, unless the office building is partially
constructed at the time that A contracts to purchase the building.
Example 2. Turnkey contract. City B issues bonds to finance a new
office building. B enters into a turnkey contract with developer D under
which D agrees to provide B with a completed building on a specified
completion date on land currently owned by D. Under the agreement, D
holds title to the land and building and assumes any risk of loss until
the completion date, at which time title to the land and the building
will be transferred to B. No construction has been performed by the date
that B and D enter into the agreement. All payments by B to D for
construction of the building are construction expenditures because all
the payments are properly capitalized to the cost of the building, but
payments by B to D allocable to the acquisition of the land are not
construction expenditures.
Example 3. Right-of-way. P, a public agency, issues bonds to finance
the acquisition of a right-of-way and the construction of sewage lines
through numerous parcels of land. The right-of-way is acquired primarily
through P' s exercise of its powers of eminent domain. As of the issue
date, P reasonably expects that it will take approximately 2 years to
acquire the entire right-of-way because of the time normally required
for condemnation proceedings. No expenditures for the acquisition of the
right-of-way are construction expenditures because they are costs
incurred to acquire an interest in existing real property.
Example 4. Subway cars. City C issues bonds to finance new subway
cars. C reasonably expects that it will take more than 6 months for the
subway cars to be constructed to C's specifications. The subway cars are
constructed personal property. Alternatively, if
[[Page 700]]
the builder of the subway cars informs C that it will only take 3 months
to build the subway cars to C's specifications, no payments for the
subway cars are construction expenditures.
Example 5. Fractional interest in property. U, a public agency,
issues bonds to finance an undivided fractional interest in a newly
constructed power-generating facility. U contributes its ratable share
of the cost of building the new facility to the project manager for the
facility. U's contributions are construction expenditures in the same
proportion that the total expenditures for the facility qualify as
construction expenditures.
Example 6. Park land. City D issues bonds to finance the purchase of
unimproved land and the cost of subsequent improvements to the land,
such as grading and landscaping, necessary to transform it into a park.
The costs of the improvements are properly capitalizable to the cost of
the land, and therefore, are construction expenditures, but expenditures
for the acquisition of the land are not.
(h) Reasonable retainage definition. Reasonable retainage means an
amount, not to exceed 5 percent of available construction proceeds as of
the end of the fourth spending period, that is retained for reasonable
business purposes relating to the property financed with the proceeds of
the issue. For example, a reasonable retainage may include a retention
to ensure or promote compliance with a construction contract in
circumstances in which the retained amount is not yet payable, or in
which the issuer reasonably determines that a dispute exists regarding
completion or payment.
(i) Available construction proceeds--(1) Definition in general.
Available construction proceeds has the meaning used in section
148(f)(4)(C)(vi). For purposes of this definition, earnings include
earnings on any tax-exempt bond. Pre-issuance accrued interest and
earnings thereon may be disregarded. Amounts that are not gross proceeds
as a result of the application of the universal cap under Sec. 1.148-
6(b)(2) are not available construction proceeds.
(2) Earnings on a reasonably required reserve or replacement fund.
Earnings on any reasonably required reserve or replacement fund are
available construction proceeds only to the extent that those earnings
accrue before the earlier of the date construction is substantially
completed or the date that is 2 years after the issue date. An issuer
may elect on or before the issue date to exclude from available
construction proceeds the earnings on such a fund. If the election is
made, the rebate requirement applies to the excluded amounts from the
issue date.
(3) Reasonable expectations test for future earnings. For purposes
of determining compliance with the spending requirements as of the end
of each of the first three spending periods, available construction
proceeds include the amount of future earnings that the issuer
reasonably expected as of the issue date.
(4) Issuance costs. Available construction proceeds do not include
gross proceeds used to pay issuance costs financed by an issue, but do
include earnings on such proceeds. Thus, an expenditure of gross
proceeds of an issue for issuance costs does not count toward meeting
the spending requirements. The expenditure of earnings on gross proceeds
used to pay issuance costs does count toward meeting those requirements.
If the spending requirements are met and the proceeds used to pay
issuance costs are expended by the end of the fourth spending period,
those proceeds and the earnings thereon are treated as having satisfied
the rebate requirement.
(5) One and one-half percent penalty in lieu of arbitrage rebate.
For purposes of the spending requirements of paragraph (e) of this
section, available construction proceeds as of the end of any spending
period are reduced by the amount of penalty in lieu of arbitrage rebate
(under paragraph (k) of this section) that the issuer has paid from
available construction proceeds before the last day of the spending
period.
(6) Payments on purpose investments and repayments of grants.
Available construction proceeds do not include--
(i) Sale or investment proceeds derived from payments under any
purpose investment of the issue; or
(ii) Repayments of grants (as defined in Sec. 1.148-6(d)(4))
financed by the issue.
(7) Examples. The operation of this paragraph (i) is illustrated by
the following examples:
Example 1. Treatment of investment earnings. City F issues bonds
having an issue price of $10,000,000. F deposits all of the proceeds of
the issue into a construction fund to be used
[[Page 701]]
for expenditures other than costs of issuance. F estimates on the issue
date that, based on reasonably expected expenditures and rates of
investment, earnings on the construction fund will be $800,000. As of
the issue date and the end of each of the first three spending periods,
the amount of available construction proceeds is $10,800,000. To qualify
as a construction issue, F must reasonably expect on the issue date that
at least $8,100,000 (75 percent of $10,800,000) will be used for
construction expenditures. In order to meet the 10 percent spending
requirement at the end of the first spending period, F must spend at
least $1,080,000. As of the end of the fourth spending period, F has
received $1,100,000 in earnings. In order to meet the spending
requirement at the end of the fourth spending period, however, F must
spend all of the $11,100,000 of actual available construction proceeds
(except for reasonable retainage not exceeding $555,000).
Example 2. Treatment of investment earnings without a reserve fund.
City G issues bonds having an issue price of $11,200,000. G does not
elect to exclude earnings on the reserve fund from available
construction proceeds. G uses $200,000 of proceeds to pay issuance costs
and deposits $1,000,000 of proceeds into a reasonably required reserve
fund. G deposits the remaining $10,000,000 of proceeds into a
construction fund to be used for construction expenditures. On the issue
date, G reasonably expects that, based on the reasonably expected date
of substantial completion and rates of investment, total earnings on the
construction fund will be $800,000, and total earnings on the reserve
fund to the date of substantial completion will be $150,000. G
reasonably expects that substantial completion will occur during the
fourth spending period. As of the issue date, the amount of available
construction proceeds is $10,950,000 ($10,000,000 originally deposited
into the construction fund plus $800,000 expected earnings on the
construction fund and $150,000 expected earnings on the reserve fund).
To qualify as a construction issue, G must reasonably expect on the
issue date that at least $8,212,500 will be used for construction
expenditures.
Example 3. Election to exclude earnings on a reserve fund. The facts
are the same as Example 2, except that G elects on the issue date to
exclude earnings on the reserve fund from available construction
proceeds. The amount of available construction proceeds as of the issue
date is $10,800,000.
(j) Election to treat portion of issue used for construction as
separate issue--(1) In general. For purposes of paragraph (e) of this
section, if any proceeds of an issue are to be used for construction
expenditures, the issuer may elect on or before the issue date to treat
the portion of the issue that is not a refunding issue as two, and only
two, separate issues, if--
(i) One of the separate issues is a construction issue as defined in
paragraph (f) of this section;
(ii) The issuer reasonably expects, as of the issue date, that this
construction issue will finance all of the construction expenditures to
be financed by the issue; and
(iii) The issuer makes an election to apportion the issue under this
paragraph (j)(1) in which it identifies the amount of the issue price of
the issue allocable to the construction issue.
(2) Example. The operation of this paragraph (j) is illustrated by
the following example.
Example. City D issues bonds having an issue price of $19,000,000.
On the issue date, D reasonably expects to use $10,800,000 of bond
proceeds (including investment earnings) for construction expenditures
for the project being financed. D deposits $10,000,000 in a construction
fund to be used for construction expenditures and $9,000,000 in an
acquisition fund to be used for acquisition of equipment not qualifying
as construction expenditures. D estimates on the issue date, based on
reasonably expected expenditures and rates of investment, that total
earnings on the construction fund will be $800,000 and total earnings on
the acquisition fund will be $200,000. Because the total construction
expenditures to be financed by the issue are expected to be $10,800,000,
the maximum available construction proceeds for a construction issue is
$14,400,000 ($10,800,000 divided by 0.75). To determine the maximum
amount of the issue price allocable to a construction issue, the
estimated investment earnings allocable to the construction issue are
subtracted. The entire $800,000 of earnings on the construction fund are
allocable to the construction issue. Only a portion of the $200,000 of
earnings on the acquisition fund, however, are allocable to the
construction issue. The total amount of the available construction
proceeds that is expected to be used for acquisition is $3,600,000
($14,400,000-$10,800,000). The portion of earnings on the acquisition
fund that is allocable to the construction issue is $78,261
($200,000x$3,600,000/$9,200,000). Accordingly, D may elect on or before
the issue date to treat up to $13,521,739 of the issue price as a
construction issue ($14,400,000-$800,000-$78,261). D's election must
specify the amount of the issue price treated as a construction issue.
The balance of the issue price is treated as a separate nonconstruction
issue that is subject to the rebate requirement unless it meets another
[[Page 702]]
exception to arbitrage rebate. Because the financing of a construction
issue is a separate governmental purpose under Sec. 1.148-9(h), the
election causes the issue to be a multipurpose issue under that section.
(k) One and one-half percent penalty in lieu of arbitrage rebate--
(1) In general. Under section 148(f)(4)(C)(vii), an issuer of a
construction issue may elect on or before the issue date to pay a
penalty (the 1\1/2\ percent penalty) to the United States in lieu of the
obligation to pay the rebate amount on available construction proceeds
upon failure to satisfy the spending requirements of paragraph (e) of
this section. The 1\1/2\ percent penalty is calculated separately for
each spending period, including each semiannual period after the end of
the fourth spending period, and is equal to 1.5 percent times the
underexpended proceeds as of the end of the spending period. For each
spending period, underexpended proceeds equal the amount of available
construction proceeds required to be spent by the end of the spending
period, less the amount actually allocated to expenditures for the
governmental purposes of the issue by that date. The 1\1/2\ percent
penalty must be paid to the United States no later than 90 days after
the end of the spending period to which it relates. The 1\1/2\ percent
penalty continues to apply at the end of each spending period and each
semiannual period thereafter until the earliest of the following--
(i) The termination of the penalty under paragraph (l) of this
section;
(ii) The expenditure of all of the available construction proceeds;
or
(iii) The last stated final maturity date of bonds that are part of
the issue and any bonds that refund those bonds.
(2) Application to reasonable retainage. If an issue meets the
exception for reasonable retainage except that all retainage is not
spent within 3 years of the issue date, the issuer must pay the 1\1/2\
percent penalty to the United States for any reasonable retainage that
was not so spent as of the close of the 3-year period and each later
spending period.
(3) Coordination with rebate requirement. The rebate requirement is
treated as met with respect to available construction proceeds for a
period if the 1\1/2\ percent penalty is paid in accordance with this
section.
(l) Termination of 1\1/2\ percent penalty--(1)Termination after
initial temporary period. The issuer may terminate the 1\1/2\ percent
penalty after the initial temporary period (a section 148(f)(4)(C)(viii)
penalty termination) if--
(i) Not later than 90 days after the earlier of the end of the
initial temporary period or the date construction is substantially
completed, the issuer elects to terminate the 1\1/2\ percent penalty;
provided that solely for this purpose, the initial temporary period may
be extended by the issuer to a date ending 5 years after the issue date;
(ii) Within 90 days after the end of the initial temporary period,
the issuer pays a penalty equal to 3 percent of the unexpended available
construction proceeds determined as of the end of the initial temporary
period, multiplied by the number of years (including fractions of years
computed to 2 decimal places) in the initial temporary period;
(iii) For the period beginning as of the close of the initial
temporary period, the unexpended available construction proceeds are not
invested in higher yielding investments; and
(iv) On the earliest date on which the bonds may be called or
otherwise redeemed, with or without a call premium, the unexpended
available construction proceeds as of that date (not including any
amount earned after the date on which notice of the redemption was
required to be given) must be used to redeem the bonds. Amounts used to
pay any call premium are treated as used to redeem bonds. This
redemption requirement may be met by purchases of bonds by the issuer on
the open market at prices not exceeding fair market value. A portion of
the annual principal payment due on serial bonds of a construction issue
may be paid from the unexpended amount, but only in an amount no greater
than the amount that bears the same ratio to the annual principal due
that the total unexpended amount bears to the issue price of the
construction issue.
(2) Termination before end of initial temporary period. If the
construction to be financed by the construction issue is substantially
completed before the end of the initial temporary period, the
[[Page 703]]
issuer may elect to terminate the 1\1/2\ percent penalty before the end
of the initial temporary period (a section 148(f)(4)(C)(ix) penalty
termination) if--
(i) Before the close of the initial temporary period and not later
than 90 days after the date the construction is substantially completed,
the issuer elects to terminate the 1\1/2\ percent penalty;
(ii) The election identifies the amount of available construction
proceeds that will not be spent for the governmental purposes of the
issue; and
(iii) The issuer has met all of the conditions for a section
148(f)(4)(C)(viii) penalty termination, applied as if the initial
temporary period ended as of the date the required election for a
section 148(f)(4)(C)(ix) penalty termination is made. That penalty
termination election satisfies the required election for a section
148(f)(4)(C)(viii) termination.
(3) Application to reasonable retainage. Solely for purposes of
determining whether the conditions for terminating the 1\1/2\ percent
penalty are met, reasonable retainage may be treated as spent for a
governmental purpose of the construction issue. Reasonable retainage
that is so treated continues to be subject to the 1\1/2\ percent
penalty.
(4) Example. The operation of this paragraph (l) is illustrated by
the following example.
Example. City I issues a construction issue having a 20-year
maturity and qualifying for a 3-year initial temporary period. The bonds
are first subject to optional redemption 10 years after the issue date
at a premium of 3 percent. I elects, on or before the issue date, to pay
the 1\1/2\ percent penalty in lieu of arbitrage rebate. At the end of
the 3-year temporary period, the project is not substantially completed,
and $1,500,000 of available construction proceeds of the issue are
unspent. At that time, I reasonably expects to need $500,000 to complete
the project. I may terminate the 1\1/2\ percent penalty in lieu of
arbitrage rebate with respect to the excess $1,500,000 by electing to
terminate within 90 days of the end of the initial temporary period;
paying a penalty to the United States of $135,000 (3 percent of
$1,500,000 multiplied by 3 years); restricting the yield on the
investment of unspent available construction proceeds for 7 years until
the first call date, although any portion of these proceeds may still be
spent on the project prior to that call date; and using the available
construction proceeds that, as of the first call date, have not been
allocated to expenditures for the governmental purposes of the issue to
redeem bonds on that call date. If I fails to make the termination
election, I is required to pay the 1\1/2\ percent penalty on unspent
available construction proceeds every 6 months until the latest maturity
date of bonds of the issue (or any bonds of another issue that refund
such bonds).
(m) Payment of penalties. Each penalty payment under this section
must be paid in the manner provided in Sec. 1.148-3(g). See Sec. 1.148-
3(h) for rules on failures to pay penalties under this section.
[T.D. 8476, 58 FR 33535, June 18, 1993; 58 FR 44452, Aug. 23, 1993]