Part I — 0919 Publ 5271 (PDF)

Basic Concepts and Definitions that Apply for the Arbitrage Requirements

Before exploring the yield restriction and rebate rules, we’ll explain some basic concepts that apply for the arbitrage requirements.

Definitions

Gross Proceeds - Gross proceeds of a bond issue include proceeds and replacement proceeds.

Proceeds ² include sale proceeds, investment proceeds and transferred proceeds.

Sale proceeds are amounts the issuer receives from the sale of the bond issue, including amounts used to pay underwriters’ discount and certain accrued interest on the bonds.

Investment proceeds are amounts received from investing proceeds of an issue. For example, if the issuer invests sale proceeds and earns interest, that interest is considered investment proceeds.

Transferred proceeds may result when an issuer issues tax-exempt bonds (the refunding bonds) to refund an outstanding issue of tax-exempt bonds (the refunded bonds). Unspent proceeds of the refunded bonds may transfer to and become proceeds of the refunding bonds, and are no longer considered proceeds of the refunded bonds.

Replacement proceeds ³ are monies that would have been used to finance the project if the bonds had not been issued. Replacement proceeds may also include amounts expected to pay debt service on the bonds, including sinking funds (such as a debt service fund, redemption fund, reserve fund or a replacement fund) and pledged funds (generally meaning any amount pledged to pay principal of or interest on the bonds).

Investment Property ⁴ includes any security (for example, a share of stock in a corporation), any obligation (for example, debt obligations such as U.S. Treasury obligations and agency bonds), any annuity contract and any other kind of investment-type property (for example, guaranteed investment contracts). Cash is not investment property. For issues of governmental and qualified 501(c)(3) bonds, investments in other tax-exempt governmental bonds and tax-exempt

qualified 501(c)(3) bonds (bonds not subject to the Alternative Minimum Tax) are not investment property under IRC Section 148(b)(3). For issues of other types of bonds, no tax-exempt bond is investment property. Consequently, investments in these tax-exempt bonds are not subject to the arbitrage requirements, and earnings received from these bonds are not subject to the yield restriction or rebate requirements. ⁵ Investment property can be a purpose or nonpurpose investment. ⁶

A purpose investment is one acquired for the governmental purpose of an issue. For example, if an issuer issued bonds to make a loan to a 501(c)(3) organization or to fund student loans, the loans the issuer makes to the 501(c)(3) or students are investments but because the bonds were issued for this purpose, these loans are “purpose investments.”

2 Treas. Reg. Section 1.148-1(b).

3 Treas. Reg. Section 1.148-1(c).

4 IRC Section 148(b)(2).

5 Treas. Reg. Section 1.148-2(d)(2)(v). Generally, investments in bonds subject to the Alternative Minimum Tax (AMT bonds) made with non-AMT bond proceeds are subject to yield restriction, but investment in AMT bonds made with AMT bond proceeds are not. Similarly, investments in non-AMT bonds made with non-AMT bond proceeds are not subject to yield restriction. See IRC Section 148(b)(3).

6 Treas. Reg. Section 1.148-1(b).

A nonpurpose investment is an investment that is not a purpose investment. For example, if the issuer sells bonds to build a school but invests some of those proceeds while construction is ongoing, the investments are not acquired for the governmental purpose of the issue (construction of the school) so they are nonpurpose investments. Examples of a nonpurpose investment include buying U.S. Treasury notes during the construction period as a temporary investment until the funds are spent on the project, or buying federal agency bonds to hold in a debt service reserve fund.

Funds and Accounts Descriptions - Issuers and conduit borrowers create funds and accounts in connection with a bond issue in which bond proceeds are deposited. Below is a description of certain funds and accounts commonly used in tax-exempt bond financings and the typical use of proceeds deposited in each type of fund or account. Frequently, there will be more than one type of fund for a bond issue, and for each type, there may be more than one account. For example, there could be several construction accounts for separate projects within a construction fund.

Construction fund or project fund - An issuer or conduit borrower might establish a construction or project fund into which it will deposit bond proceeds to be used to pay costs of the project. This fund might also include proceeds to pay capitalized interest and costs of issuing the bonds (or proceeds for these costs may be held in separate funds or accounts).

Debt service fund and bona fide debt service fund - An issuer or conduit borrower might establish a debt service fund to hold revenues or other monies to pay upcoming debt service payments on the bonds. A bona fide debt service fund is used for proper matching of annual revenues and debt service. Revenues are deposited into the fund until needed to pay debt service. The fund generally must be depleted at least once each bond year to qualify as a bona fide debt service fund. ⁷

Reserve fund and reasonably required reserve or replacement fund - Reserve funds secure payment of debt service on the bonds in the event the issuer is unable to pay debt service. A reasonably required reserve or replacement fund is a fund in which gross proceeds do not exceed the lesser of:

10% of the principal amount of the issue,
Maximum annual debt service on the bonds, or
125% of the average annual debt service on the bonds. ⁸

Refunding escrow fund - An issuer might establish a refunding escrow fund to hold monies to be used to pay principal, interest and premium, if any, on one or more prior bond issues (the refunded bonds). These funds might contain proceeds of a refunding issue and possibly other amounts, such as tax receipts or other revenues pledged to pay off the refunded bonds. A refunding escrow may be associated with a current refunding or an advance refunding bond issue.

A current refunding bond refunds bonds that are redeemed within 90 days of the refunding bonds being issued. ⁹

7 Treas. Reg. Section 1.148-1(b). Generally, “bond year” means each one-year period that ends on the day selected by the issuer. The requirements for depletion appear in the definition of “bona fide debt service fund.”

8 Treas. Reg. Section 1.148-2(f)(2)(ii). For a refunding issue, a reserve is reasonably required for purposes of this exception only if the aggregate amount invested in higher yielding investments for both the refunding issue and the refunded issue does not exceed these limits by reference only to the refunding issue (whether or not the proceeds of the refunded issue have become transferred proceeds). Treas. Reg. Section 1.148-9(e).

9 Treas. Reg. Section 1.150-1(d)(3).

An advance refunding bond refunds bonds that are redeemed more than 90 days after the refunding bonds are issued. ¹⁰

Cost of issuance fund - An issuer or conduit borrower might establish a cost of issuance fund to deposit bond proceeds to be used to pay various costs of issuing bonds. These costs include, but are not limited to, payment for the services of bond counsel, underwriter’s counsel, financial advisor, verification agent, rating agencies and fees for printing offering documents.

10 The Tax Cuts and Jobs Act (Public Law No. 115-97, 131 Stat. 2054 (2017)) repealed the exclusion from gross income for interest on bonds issued to advance refund another bond. The repeal applies to advance refunding bonds issued after December 31, 2017. A bond is classified as an advance refunding if it is issued more than 90 days before the redemption of the refunded bonds.