Part V provides information — 0919 Publ 5271 (PDF)

6-Month Spending Exception

If the requirements of the 6-month spending exception are met, the issue is treated as satisfying the rebate requirements for the proceeds meeting that exception. This means that earnings on investments of certain gross proceeds of the issue that exceed the yield on the issue don’t need to be paid as rebate to the U.S. Treasury. Generally, the issuer must meet both the following requirements:

The issuer must allocate the gross proceeds to expenditures for the governmental purposes of the issue within the 6-month period beginning on the issue date. For this purpose, gross proceeds do not include gross proceeds:

a) Held in a bona fide debt service fund or a reasonably required reserve or replacement fund,

b) Not previously anticipated to become gross proceeds but that become gross proceeds after the end of the 6-month spending period,

c) That are proceeds derived from any purpose investment of the issue, and

d) That are repayments of certain grants financed by the issue.

If the issue is a governmental bond issue other than TRANs or if the issue is qualified 501(c)(3) bonds, the 6-month time period is extended to one year for a limited amount of gross proceeds.

The issuer meets the rebate requirements for the issue’s proceeds (excluding earnings on amounts in any bona fide debt service fund) not covered by the 6-month exception.

When an issuer satisfies the requirements for the 6-month spending exception, it may retain earnings on only the gross proceeds specifically described by the exception. The 6-month spending exception does not create an exception for amounts in a reasonably required reserve or replacement fund or for unanticipated gross proceeds that appear after the 6-month period.

TRANs are treated as meeting the 6-month spending exception for the issue’s net proceeds ³⁶

and any investment earnings on those net proceeds if the issuer meets certain IRC requirements. ³⁷

36 IRC Section 150(a)(3).

37 IRC Section 148(f)(4)(B)(iii).

18-Month Spending Exception

An issuer satisfying the requirements of the 18-month spending exception may retain certain investment earnings during that 18-month period starting on the issue date. The three requirements are:

The issuer must allocate gross proceeds to expenditures for a governmental purpose of the bonds under the following schedule, with the periods starting on the issue date of the bonds:

a) At least 15% of the proceeds are allocated within 6 months,

b) At least 60% within 12 months, and

c) 100% within 18 months.

The spending requirement for the third period allows for a limited amount of unspent proceeds in connection with reasonable retainage ³⁸ (retention to ensure compliance with a construction contract), if the reasonable retainage is allocated to expenditures within 30 months of the issue date. An issuer’s failure to meet the spending requirements will be disregarded if the issuer exercised due diligence to complete the financed project and the amount of the proceeds that didn’t meet the schedule doesn’t exceed the lesser of 3% of the bond’s issue price or $250,000. ³⁹ As with the 6-month spending exception, gross proceeds has a special definition for applying the spending schedule. ⁴⁰

The issuer must meet the rebate requirement for all proceeds not required to be spent within the 18-month spending period (excluding earnings on a bona fide debt service fund).
All the bond’s gross proceeds, as defined for the 18-month spending exception, must also qualify for the 3-year temporary period available under the yield restriction requirements.

As is the case for the 6-month spending exception, the 18-month spending exception does not create an exception for amounts in a reasonably required reserve or replacement fund. The 18-month spending exception also doesn’t apply to a bond issue any portion of which is treated as meeting the rebate requirement under the 2-year construction spending exception. ⁴¹

2-Year Spending Exception

The 2-year spending exception applies only to non-refunding construction issues that finance property owned by a governmental unit or a 501(c)(3) organization. To qualify as a construction issue, the issuer must reasonably expect, as of the issue date, that at least 75% of the “available construction proceeds” ⁴² of the issue will be allocated to construction expenditures. ⁴³ If the issue meets the requirements of the 2-year construction spending exception, then the issue is treated as meeting the rebate requirements for available construction proceeds—with the result that arbitrage earnings on investments of those proceeds are not required to be paid to the U.S. Treasury.

38 Treas. Reg. Section 1.148-7(d)(2) and Treas. Reg. Section 1.148-7(h).

39 Treas. Reg. Section 1.148-7(b)(4).

40 Treas. Reg. Section 1.148-7(d)(3)(i).

41 Treas. Reg. Section 1.148-7(d)(4).

42 The term “available construction proceeds” is defined in IRC Section 148(f)(4)(C)(vi) and Treas. Reg. Section 1.148-7(i).

43 Treas. Reg. Section 1.148-7(g).

Generally, an issuer meets the requirements of the 2-year spending exception if it allocates available construction proceeds to expenditures for governmental purposes of the issue according to the following schedule (with periods starting on the issue date):

At least 10% of the proceeds are allocated within 6 months,
At least 45% within 1 year,
At least 75% within 18 months, and
100% within 2 years.

The spending requirement for this fourth and final period allows limited unspent proceeds for reasonable retainage ⁴⁴ (retention to ensure compliance with a construction contract), if the reasonable retainage is allocated to expenditures within 3 years of the issue date. If the issuer doesn’t meet the requirements of the final spending period, there is an exception if:

The unspent proceeds do not exceed the lesser of 3% of the issue price or $250,000, and
The issuer exercises due diligence to complete the project. ⁴⁵

An issuer of a construction issue may elect by the issue date to pay a “penalty in lieu of rebate” under the 2-year construction spending exception. ⁴⁶

Special Exceptions

Two additional exceptions to the rebate requirement are the small issuer exception for governmental bonds and the bona fide debt service fund exception.

Small Issuer Exception

A governmental unit that does not expect to issue more than $5 million of tax-exempt governmental bonds in a calendar year might be eligible for an exception from the rebate requirements for proceeds of a governmental bond issue issued during that calendar year. ⁴⁷

The limit is increased to $15 million for bonds issued to finance construction of public school facilities. ⁴⁸ To determine the amount of bonds that will be issued, the issuer must include certain additional tax-exempt governmental bonds issued by any:

Entity (other than political subdivisions) that issues bonds on behalf of the issuer; and
Subordinate entity (for example, an entity that is directly or indirectly controlled by the issuer, per Treas. Reg. Section 1.150-1(e)).

The issuer must also include any bonds issued by an entity formed or otherwise used to avoid the amount limitation. ⁴⁹ An issuer may exclude certain refunding bonds when computing the limit. ⁵⁰

In addition to the limit on the amount of governmental bonds that an issuer expects to issue, an issue must meet these requirements to qualify for the small issuer exception:

The issue is issued by a governmental unit with general taxing powers, ⁵¹ and
95% or more of the proceeds of the issue (other than those in a reasonably required reserve

or replacement fund) are to be used for the issuer’s local governmental activities.

44 IRC Section 148(f)(4)(C)(iii), Treas. Reg. Section 1.148-7(e)(2) and Treas. Reg. Section 1.148-7(h).

45 Treas. Reg. Section 1.148-7(b)(4).

46 IRC Section 148(f)(4)(C)(vii) and Treas. Reg. Section 1.148-7(k).

47 IRC Section 148(f)(4)(D). All proceeds are excepted, including proceeds in a reasonably required reserve or replacement fund, if any.

48 IRC Section 148(f)(4)(D)(vii).

49 Treas. Reg. Section 1.148-8(c)(2)(iii).

50 IRC Section 148(f)(4)(D)(v).

51 An issuer does not have general taxing power if the issuer’s ability to tax is contingent on approval by another governmental unit. Treas. Reg. Section 1.148-8(b). See also, IRC Section 148(f)(4)(D)(iv). 14

Bona Fide Debt Service Fund Exception

Certain earnings on bona fide debt service funds are exempt from the rebate requirement ⁵² if the issue meets either of the following criteria:

The gross earnings on the fund for a bond year are less than $100,000. The issue meets this requirement if the issue has an average annual debt service not greater than $2,500,000. ⁵³
The issue consists of governmental bonds, the issue has an average maturity of at least five years, and the bonds bear interest at a fixed rate. ⁵⁴

52 IRC Section 148(f)(4)(A)(ii).

53 Treas. Reg. Section 1.148-3(k).

54 IRC Section 148(f)(4)(A).