Qualified Zone Academy Bonds

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8755]

RIN 1545-AV74

Qualified Zone Academy Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations relating to the

federal income tax treatment of qualified zone academy bonds. The

regulations in this document provide needed guidance to holders and

issuers of qualified zone academy bonds. The text of the temporary

regulations also serves as the text of the proposed regulations set

forth in the notice of proposed rulemaking on this subject in the

Proposed Rules section of this issue of the Federal Register.

DATES: These regulations are effective January 1, 1998.

FOR FURTHER INFORMATION CONTACT: Timothy L. Jones, (202) 622-3980 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 226(a) of the Taxpayer Relief Act of 1997, Pub. L. No. 105-

34, 111 Stat. 788 (1997), amended the Internal Revenue Code (Code) by

redesignating section 1397E as section 1397F and adding a new section

1397E. Section 1397E authorizes a new type of debt instrument known as

a qualified zone academy bond.

Explanation of Provisions

In General

A qualified zone academy bond is a taxable bond issued by a state

or local government the proceeds of which are used to improve certain

eligible public schools. In lieu of receiving periodic interest

payments from the issuer, an eligible holder of a qualified zone

academy bond is generally allowed annual federal income tax credits

while the bond is outstanding. These credits compensate the holder for

lending money to the issuer and function as payments of interest on the

bond.

These temporary regulations provide rules for the federal income

tax treatment of qualified zone academy bonds. These regulations

generally treat the allowance of the credit as if it were a payment of

interest on the bond. These regulations also provide rules to determine

(1) the credit rate, (2) the discount rate used to present value

private business contributions, and (3) the discount rate used to

determine the maximum term of a qualified zone academy bond.

These regulations generally do not provide guidance on the

statutory requirements that must be met for a bond to qualify as a

qualified zone academy bond. Section 1397E(d) sets forth a number of

detailed requirements that must be met for a bond to qualify

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as a qualified zone academy bond. In particular, section 1397E(d)(1)(C)

requires the issuer to certify (1) that it has written assurances that

private entities have agreed to contribute a certain level of goods or

services to the qualified zone academy, and (2) that it has the written

approval of the eligible local education agency for the bond issuance.

The Treasury and the IRS intend that these certifications will be

respected and may be relied on by taxpayers if the certifications are

reasonably made.

In addition, section 1397E(d)(1)(A) requires that 95 percent or

more of the proceeds of an issue of qualified zone academy bonds are to

be used for a qualified purpose described in section 1397E(d)(5) with

respect to a qualified zone academy as defined in section 1397E(d)(4).

The Treasury and the IRS intend that the qualified purposes set forth

in section 1397E(d)(5) are to be broadly interpreted. The Treasury and

the IRS also intend that, if an issuer is unable to actually spend 95

percent or more of the proceeds of a qualified zone academy bond for a

qualified purpose, the issuer may apply remedial actions similar to the

remedial actions set forth in Sec. 1.142-2 to preserve the

qualification of a bond. Further, the Treasury and the IRS intend that

taxpayers may rely on an issuer's determination that a public school

(or academic program within a public school) is a qualified zone

academy for purposes of section 1397E(d)(4) if the determination has a

reasonable basis. The Treasury and IRS request comments on whether

additional guidance is needed with respect to the section 1397E(d)

requirements.

Section 1397E(e) imposes a national limitation on the amount of

qualified zone academy bonds that can be issued. For 1998 and 1999, the

IRS will publish a revenue procedure allocating the national limitation

among the States and the possessions.

The Credit Allowance

A qualified zone academy bond provides an annual federal income tax

credit to certain holders. Under the regulations, the credit is deemed

paid on the credit allowance date--the last day of each one-year

accrual period on the bond. A taxpayer that receives a credit on a

credit allowance date may use the credit to offset its income tax

liability for the taxable year that includes the credit allowance date.

There are two limitations on the use of the credit. First, only

eligible taxpayers holding the bond on the credit allowance date may

claim the credit. Section 1397E(d)(6) defines an eligible taxpayer as a

bank, an insurance company, or a corporation actively engaged in the

business of lending money. Second, an eligible taxpayer may claim the

credit only to the extent the taxpayer has a tax liability for the

taxable year that includes the credit allowance date. See section

1397E(c). The credit is nonrefundable.

Treatment of the Credit as Interest

The regulations treat the credit on a qualified academy zone bond

as if it were a payment of qualified stated interest. This treatment

effectively conforms the treatment of the credit with the treatment of

interest income on debt instruments. Thus, for example, a holder that

uses an accrual method of accounting accrues the credit amount over the

one-year accrual period that ends on the credit allowance date.

Adjustment When Credit is Limited or Disallowed

In two situations the holder of a qualified zone academy bond on a

credit allowance date will not be able to use some or all of the credit

to offset its tax liability. First, if the holder on a credit allowance

date is not an eligible taxpayer (a bank, insurance company, or

corporation actively engaged in the business of lending money), no

credit is allowed. Second, the amount of the credit may exceed the

income tax liability of a holder that is an eligible taxpayer. In this

second case, because the credit is nonrefundable, some or all of the

credit will not be used.

In these situations, the regulations allow the holder to adjust its

income by deducting the amount of the unused credit. This deduction is

allowed for the taxable year that includes the credit allowance date.

The Treasury and the IRS request comments on whether this adjustment

works appropriately when an eligible taxpayer holds a qualified zone

academy bond on the credit allowance date but has an income tax

liability (determined without regard to the credit) that is less than

the amount of the credit.

Credit Rate

Section 1397E(b)(2) authorizes the Treasury to establish a single,

uniform credit rate that will permit the issuance of qualified zone

academy bonds without discount and without interest cost to the issuer.

This section also requires the Treasury to adjust the credit allowance

rate on a monthly basis to reflect changes in market interest rates.

It is not possible to determine a uniform credit rate that would

permit all qualified zone academy bonds to be issued at par. Some

borrowers are less creditworthy than others and, therefore, borrow at

less favorable rates. In addition, because section 1397E(b)(2) requires

the Secretary to set the credit rate in the month before the bond is

issued, changes in market interest rates between the time the rate is

set and the time a qualified zone academy bond is issued can result in

a bond being issued at a price that is different than par.

The regulations provide a single monthly rate that will minimize

the discount or premium on qualified zone academy bonds. Specifically,

the regulations provide that the credit rate is 110 percent of the

long-term applicable Federal rate (AFR), compounded annually, for the

month of issuance. Tying the credit rate to the AFR ensures that the

rate will be adjusted on a monthly basis to reflect changes in market

interest rates. In addition, the Treasury and the IRS believe the 10

percent spread over the long-term AFR is appropriate, in part, because

qualified zone academy bonds bear more credit and liquidity risk than

long-term Treasury bonds.

Maximum Term

Section 1397E(d)(3) sets out a formula for determining the maximum

term of a qualified zone academy bond. The formula requires the use of

a discount rate equal to the average annual interest rate of tax-exempt

obligations having a term of ten years or more. Because there is no

readily available source for this discount rate, the regulations

provide that the discount rate is 110 percent of the long-term adjusted

AFR, compounded semi-annually. The long-term adjusted AFR is published

on a monthly basis and is designed to reflect the current yield of a

risk-free tax-exempt obligation having a term of 9 years or more.

Taxable Obligation

It is possible that some qualified zone academy bonds may either

(1) provide for payments of stated interest, or (2) be issued at a

discount. The Treasury and the IRS have determined that qualified zone

academy bonds are not obligations the interest on which is excluded

from gross income under section 103(a). There are a number of reasons

for treating a qualified zone academy bond as a taxable obligation. For

example, the requirement in section 1397E(g) that a holder include the

allowed amount of the credit in gross income evidences an intention to

treat qualified zone academy bonds as taxable, not tax-exempt,

obligations.

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Coordination With Estimated Tax Rules

The regulations do not address the estimated tax consequences of

holding a qualified zone academy bond. The Treasury and the IRS request

comments on whether there is a need to coordinate the regulations with

the estimated tax rules and, if so, how they might be coordinated.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

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

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations and, because the regulations do not

impose a collection of information on small entities, the Regulatory

Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue Code, these temporary

regulations will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on their impact on small

business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

adding an entry in numerical order to read as follows:

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

Section 1.1397E-1T also issued under 26 U.S.C. 1397E(b) and

1397E(d). * * *

Par. 2. Section 1.1397E-1T is added to read as follows:

Sec. 1.1397E-1T Qualified zone academy bonds (temporary).

(a) Overview. In general, a qualified zone academy bond is a

taxable bond issued by a state or local government the proceeds of

which are used to improve certain eligible public schools. An eligible

taxpayer that holds a qualified zone academy bond generally is allowed

annual federal income tax credits in lieu of periodic interest

payments. These credits compensate the eligible taxpayer for lending

money to the issuer and function as payments of interest on the bond.

Accordingly, this section generally treats the allowance of a credit as

if it were a payment of interest on the bond. In addition, this section

provides rules to determine the credit rate, the present value of

qualified contributions from private entities, and the maximum term of

a qualified zone academy bond.

(b) Credit rate. The credit rate for a qualified zone academy bond

is equal to 110 percent of the long-term applicable Federal rate (AFR),

compounded annually, for the month in which the bond is issued. The

Internal Revenue Service publishes this figure each month in a revenue

ruling that is published in the Internal Revenue Bulletin. See

Sec. 601.601(d)(2)(ii)(b) of this Chapter.

(c) Private business contribution requirement. To determine the

present value (as of the issue date) of qualified contributions from

private entities under section 1397E(d)(2), the issuer must use a

reasonable discount rate. The credit rate determined under paragraph

(b) of this section is a reasonable discount rate.

(d) Maximum term. The maximum term for a qualified zone academy

bond is determined under section 1397E(d)(3) by using a discount rate

equal to 110 percent of the long-term adjusted AFR, compounded semi-

annually, for the month in which the bond is issued. The Internal

Revenue Service publishes this figure each month in a revenue ruling

that is published in the Internal Revenue Bulletin. See

Sec. 601.601(d)(2)(ii)(b) of this Chapter.

(e) Tax credit--(1) Eligible taxpayer. An eligible taxpayer (within

the meaning of section 1397E(d)(6)) that holds a qualified zone academy

bond on a credit allowance date is allowed a tax credit against the

federal income tax imposed on the taxpayer for the taxable year that

includes the credit allowance date. The amount of the credit is equal

to the product of the credit rate and the outstanding principal amount

of the bond on the credit allowance date. The credit is subject to a

limitation based on the eligible taxpayer s income tax liability. See

section 1397E(c).

(2) Ineligible taxpayer. A taxpayer that is not an eligible

taxpayer is not allowed a credit.

(f) Treatment of the allowance of the credit as a payment of

interest--(1) General rule. The holder of a qualified zone academy bond

must treat the bond as if it pays qualified stated interest (within the

meaning of Sec. 1.1273-1(c)) on each credit allowance date. The amount

of the deemed payment of interest on each credit allowance date is

equal to the product of the credit rate and the outstanding principal

amount of the bond on that date. Thus, for example, if the holder uses

an accrual method of accounting, the holder must accrue as interest

income the amount of the credit over the one-year accrual period that

ends on the credit allowance date.

(2) Adjustment if the holder cannot use the credit to offset a tax

liability. If a holder holds a qualified zone academy bond on the

credit allowance date but cannot use all or a portion of the credit to

reduce its income tax liability (for example, because the holder is not

an eligible taxpayer or because the limitation in section 1397E(c)

applies), the holder is allowed a deduction for the taxable year that

includes the credit allowance date. The amount of the deduction is

equal to the amount of the unused credit deemed paid on the credit

allowance date.

(g) Not a tax-exempt obligation. A qualified zone academy bond is

not an obligation the interest on which is excluded from gross income

under section 103(a).

(h) Cross-references. See section 171 and the regulations

thereunder for rules relating to amortizable bond premium. See

Sec. 1.61-7(c) for the seller s treatment of a bond sold between

interest payment dates (credit allowance dates) and Sec. 1.61-7(d) for

the buyer s treatment of a bond purchased between interest payment

dates (credit allowance dates).

(i) [Reserved]

(j) Effective date. This section applies to a qualified zone

academy bond issued on or after January 1, 1998.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: December 19, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98-21 Filed 1-6-98; 8:45 am]

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