Arbitrage Restrictions on Tax-Exempt Bonds

Federal RegisterMay 10, 1994

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-7-94]

RIN 1545-AS49

Arbitrage Restrictions on Tax-Exempt Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary

regulations.

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SUMMARY: In the Rules and Regulations portion of this issue of the

Federal Register, the IRS is issuing temporary regulations relating to

the arbitrage and related restrictions applicable to tax-exempt bonds

issued by State and local governments. The text of the temporary

regulations also serves as a portion of the text of these proposed

regulations.

DATES: Written comments and requests for a public hearing must be

received by July 11, 1994.

ADDRESSES: Send comments and requests for a public hearing to: Internal

Revenue Service, POB 7604, Ben Franklin Station, Attn: CC:DOM:CORP:T:R

(FI-7-94), room 5228, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT: William P. Cejudo at 202-622-3980 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collection of information should be sent to

the Office of Management and Budget, Attention: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attention: IRS Reports Clearance Officer, PC:FP, Washington,

DC 20224.

The collection of information is in Sec. 1.148-4T(h)(2)(ix). This

information is required by the IRS to verify that an issuer of tax-

exempt bonds is properly complying with the arbitrage restrictions

under section 148. The recordkeepers are States and political

subdivisions that issue bonds and entities that issue bonds on behalf

of States or political subdivisions.

Estimated total annual recordkeeping burden: 6000 hours.

Estimated average annual burden per recordkeeper: 2 hours.

Estimated number of recordkeepers: 3000.

Background

Sections 1.103-8, 1.148-1T, 1.148-2T, 1.148-3T, 1.148-4T, 1.148-5T,

1.148-6T, 1.148-9T, 1.148-10T, 1.148-11T, 1.149(d)-1T, and 1.150-1T

published in the rules and regulations portion of this issue of the

Federal Register are issued to provide guidance on certain aspects of

the arbitrage and related restrictions under sections 103, 148, 149(d),

and 150 of the Internal Revenue Code. The text of those regulations

also serves as the text of these proposed regulations. The preamble to

the temporary regulations explains the regulations.

This document also proposes to amend the definition of

``investment-type property'' under the arbitrage regulations. Under

Sec. 1.148-1T, which appears elsewhere in this issue of the Federal

notice of proposed rulemaking, the term ``investment-type property''

includes a contract that would be a hedge except that it contains a

significant investment element.

For an issuer borrowing at tax-exempt rates, paying for an interest

rate cap through an up-front payment or in annual installments presents

concerns regarding the extent to which the issuer is receiving an

arbitrage benefit similar to the benefit obtained by making a

prepayment. This arbitrage benefit arises to the extent that payments

for the interest rate cap are made earlier than the period to which the

cap relates (e.g., an up-front payment for the portion of the cap fee

that relates to later years under the cap).

The proposed regulations provide specific situations in which

interest rate caps contain a significant investment element, and,

therefore, will be treated as investment-type property. First, the

issuer may not pay for the cap more quickly than in level annual

installments. Second, the cap may not hedge a bond unless that bond is

a variable rate debt instrument within the meaning of the original

issue discount regulations. Finally, the cap rate generally cannot be

less than the on-market swap rate. These provisions would apply

prospectively to bonds sold after the adoption of final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedures Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments that are submitted

timely (a signed original and eight (8) copies) to the IRS. All

comments will be available for public inspection and copying. A public

hearing may be scheduled if requested by a person that timely submits

written comments. If a public hearing is scheduled, notice of the date,

time, and place will be published in the Federal Register.

Drafting Information

The principal author of these proposed regulations is William P.

Cejudo, Office of Assistant Chief Counsel (Financial Institutions and

Products). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.103-8 (a)(5) is revised as follows:

Sec. 1.103-8 Interest on bonds to finance certain exempt facilities.

[The text of proposed paragraph (a)(5) is the same as the text of

Sec. 1.103-8T(a)(5) published elsewhere in this issue of the Federal

Par. 3. Section 1.148-1 is amended as follows:

1. Paragraph (b) is amended by removing the definition of

investment-type property.

2. Paragraph (e) is added to read as follows:

Sec. 1.148-1 Definitions and elections.

* * * * *

(e) Investment-type property--(1) In general. Investment-type

property includes any property, other than property described in

section 148(b)(2)(A), (B), (C), or (E), that is held principally as a

passive vehicle for the production of income.

(2) Non-customary prepayments. Except as otherwise provided, a

prepayment for property or services is investment-type property if a

principal purpose for prepaying is to receive an investment return from

the time the prepayment is made until the time payment otherwise would

be made. A prepayment is not investment-type property if--

(i) The prepayment is made for a substantial business purpose other

than investment return and the issuer has no commercially reasonable

alternative to the prepayment, or

(ii) Prepayments on substantially the same terms are made by a

substantial percentage of persons who are similarly situated to the

issuer but who are not beneficiaries of tax-exempt financing.

(3) Certain hedges. Investment-type property also includes a

contract that would be a hedge (within the meaning of Sec. 1.148-4(h))

except that it contains a significant investment element. An interest

rate cap contains a significant investment element if the payments for

the cap are made more quickly than in level annual installments over

the term of the cap or the cap hedges a bond that is not a variable

rate debt instrument under Sec. 1.1275-5. In addition, a cap generally

contains a significant investment element if the cap rate is less than

the on-market swap rate on the date the cap is entered into. This

paragraph (e)(3) applies to bonds sold after [Insert the date 30 days

after the date of publication of final regulations in the Federal

Par. 4. Section 1.148-1 is further amended as follows:

Sec. 1.148-1 Definitions and elections.

[The text of the further amendments proposed for this section is

the same as the text of Sec. 1.148-1T published elsewhere in this issue

of the Federal Register].

Par. 5. Section 1.148-2 is amended as follows:

Sec. 1.148-2 General arbitrage yield restriction rules.