Part II

Yield Restriction Requirements and Exceptions

The yield restriction rules provide that bonds are arbitrage bonds if the issuer expects to invest or actually invests all or part of the gross proceeds in investment property having a yield materially higher than the bond yield. The yield restriction rules apply both to purpose and nonpurpose investments. The yield restriction rules provide special treatment when proceeds are used for:

• Certain general uses of the bonds, for example, construction or refunding purposes (some of

which may have special exceptions);

• Certain types of investments depending on how the invested funds are intended to be used,

for example, a construction or escrow fund may be subject to different definitions of materially higher yield; and

• Certain classes of investments (yield is computed separately for purpose and nonpurpose

investments).

To follow the yield restriction requirements, the issuer or conduit borrower must correctly treat all investments based on the general uses of the bonds and the type and class of the investment.

Materially Higher Yield

The yield restriction rules limit investment yield on gross proceeds. Gross proceeds invested at a yield materially higher than the bond yield will result in the bonds being arbitrage bonds. ¹¹

Generally, an investment yield is materially higher if it exceeds the bond yield by more than 1/8 of 1%; ¹² however, the definition of materially higher can differ depending on the type and class of investment and the general uses of the bonds. ¹³

For example, if a fixed-yield bond issue has a yield of 5%, the investment yield on an advance refunding escrow or on replacement proceeds is not materially higher if the yield of the investments is not greater than 5.001%.

Yield Reduction Payments

In certain cases, an issuer can make a payment to the U.S. Treasury to reduce the yield on an investment (a yield reduction payment). In this case, an issuer may invest proceeds at a materially higher yield, but by paying the yield reduction payment, the issuer causes the investment yield to be treated within the permitted yield. Yield reduction payments may only be made for certain types of investments and certain types of proceeds. ¹⁶ Generally, a yield reduction payment is made at the same time and in the same manner as a rebate payment by

11 IRC Section 148(a) and Treas. Reg. Section 1.148-2(a).

12 Treas. Reg. Section 1.148-2(d)(2)(i).

13 Treas. Reg. Section 1.148-2(d)(1). If yield-restricted investments in the same class are subject to different definitions of materially higher, the definition of materially higher that produces the lowest permitted yield applies to all the investments in the class.

14 Treas. Reg. Section 1.148-2(d)(2)(ii).

15 Treas. Reg. Section 1.148-2(d)(2)(ii).

16 Treas. Reg. Section 1.148-5(c)(3).

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filing Form 8038-T, A rbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage Rebate, with the IRS. ¹⁷

Yield Computation Done for Entire Class of Investments

In figuring whether investments acquired with gross proceeds have a materially higher yield, combine similar investments into three classes ¹⁸ and compute the yield for each class. Class A includes all purpose investments that are subject to certain yield restriction limits. Class B includes the nonpurpose investments subject to yield restriction after the temporary period. Class C consists of all other nonpurpose investments.

Illustration of classes of investments and their arbitrage requirements

Note that nonpurpose investments not subject to yield restriction are subject to the rebate requirements. This means that during the temporary period Class B investments are subject to rebate requirements, even though they aren’t subject to yield restriction requirements until a later date. In this illustration, the Class B investments could be a construction fund while the Class C investments could be a reasonably required reserve fund.

Exceptions to Yield Restriction Rules

The exceptions to the yield restriction requirement are for gross proceeds:

• Held during “temporary periods,” ¹⁹

• Held in a “reasonably required reserve or replacement fund,” ²⁰ or

• Representing a “minor portion.” ²¹

Remember, if an exception applies, the issuer may invest the bond proceeds covered by the exception at an unrestricted yield, but those proceeds might be subject to the rebate requirements. For example, bond proceeds deposited in a reasonably required reserve or replacement fund are subject to rebate requirements even though an issuer can invest those proceeds at an unrestricted yield under a specific exception to the yield restriction requirements. This is an example of how an issuer may earn arbitrage, but may not keep it.

17 Treas. Reg. Section 1.148-5(c)(2).

18 Treas. Reg. Section 1.148-5(b)(2)(ii).

19 IRC Section 148(c).

20 IRC Section 148(d).

21 IRC Section 148(e).

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Temporary Period Exceptions - Exceptions Subject to a Time Limit

During a “temporary period,” the issuer may invest bond proceeds at an unrestricted yield without causing the bonds to be arbitrage bonds under the yield restriction rules. The length of the “temporary period” depends on the purpose (use) for which the bonds are issued and the type of investment (or fund) that holds the proceeds.

3-Year Temporary Period for Capital Projects

A 3-year temporary period is available for bond proceeds deposited in a construction or project fund when those proceeds are expected to be allocated to acquisition or construction costs of a capital project. ²² The temporary period begins on the date the bonds are issued and ends 3 years later. The 3-year temporary period may be extended another 2 years for a total of 5 years if the issuer and a licensed architect or engineer certify that more than 3 years are necessary to complete the capital project. This fund is made up of the net sale proceeds ²³ and investment proceeds.

The 3-year temporary period applies as long as the issuer reasonably expects as of the issue date to:

• Allocate at least 85% of the bond’s net sale proceeds for expenditures on the capital project within three years of the bond’s issue date,

• Have a binding obligation to a third party within six months of the bond’s issue date to allocate at least 5% of the net sale proceeds to expenditures for the capital project, and

• Proceed toward completing the project and allocating the net sale proceeds to expenditures with due diligence. ²⁴

Other Temporary Periods

Other temporary period exceptions to the yield restriction requirements include:

1. 13-month temporary period exceptions for bona fide debt service funds and working capital expenditures. ²⁵ The 13-month temporary period may be extended to the maturity date for issues that are tax and revenue anticipation notes (TRANs) ²⁶ if certain requirements are met.

2. 1-year temporary period for investment proceeds. ²⁷

3. 90-day temporary period for certain current refundings. The temporary period for current refunding proceeds, other than transferred proceeds, is generally 90 days. ²⁸

4. 30-day temporary periods for replacement proceeds, advance refunding proceeds and other proceeds. Replacement proceeds qualify for a 30-day temporary period. The temporary period for proceeds (other than transferred proceeds) of an advance refunding issue is generally 30 days. ²⁹ Gross proceeds not qualifying for any other special temporary period exception qualify for a 30-day temporary period exception from date of receipt. ³⁰

22 See Part V for a discussion of what it means to allocate to expenditures.

23 “Net sale proceeds” of a bond issue are the sale proceeds reduced by those sale proceeds deposited in a “reasonably required reserve or replacement fund” and proceeds invested as part of a “minor portion.” Treas. Reg. Section 1.148-1(b).

24 Treas. Reg. Section 1.148-2(e)(2).

25 Treas. Reg. Section 1.148-2(e)(5)(ii) and Treas. Reg. Section 1.148-2(e)(3)(i).

26 Treas. Reg. Section 1.148-2(e)(3)(ii).

27 Treas. Reg. Section 1.148-2(e)(6).

28 Treas. Reg. Section 1.148-9(d)(2)(ii)(A) and (B).

29 Treas. Reg. Section 1.148-9(d)(2)(i). This 30-day temporary period ends 30 days after the date the advance refunding bonds are issued.

30 Treas. Reg. Section 1.148-2(e)(7).

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Start of Temporary Period

Most temporary periods begin on the bond’s issue date. Other temporary periods begin after the issue date, such as when proceeds are received or earned (for example, investment earnings), allocated to the bonds (for example, replacement proceeds deposited in a sinking fund) or first treated as replacement proceeds. ³¹ Certain temporary periods for repayments of loans made with proceeds begin on the date of the repayment.

Temporary Periods and Refunding Bonds

For proceeds that are transferred proceeds of a refunding issue, the temporary period generally begins on the date of transfer of the proceeds and ends when it would have otherwise ended if the proceeds had remained proceeds of the refunded bonds. ³² However, in an advance refunding, for example, the 3 or 5-year temporary period for capital projects or the 13-month temporary period for working capital for the proceeds of the prior issue ends on the issue date of the advance refunding issue. ³³

Yield Restriction Exceptions Having No Time Limit

The following exceptions to the yield restriction rules apply throughout the life of the bond issue. If one of these exceptions applies, the yield restriction limitations do not apply to the proceeds or funds described in the exception.

1. Reasonably required reserve or replacement fund. ³⁴

2. Minor portion exception - This exception applies to proceeds in an amount which is the lesser of $100,000 or 5% of the sale proceeds of the issue. ³⁵

31 Treas. Reg. Section 1.148-2(e)(5).

32 Treas. Reg. Section 1.148-9(d)(2)(iii)(A).

33 Treas. Reg. Section 1.148-9(d)(2)(iii)(B).

34 Treas. Reg. Section 1.148-2(f)(2)(i).

35 Treas. Reg. Section 1.148-2(g).

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