Arbitrage Restrictions on Tax-Exempt Bonds

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8801]

RIN 1545-AU39

Arbitrage Restrictions on Tax-Exempt Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations on the arbitrage

restrictions applicable to tax-exempt bonds issued by State and local

governments. Changes to applicable law were made by the Tax Reform Act

of 1986. These regulations affect issuers of tax-exempt bonds and

provide guidance for complying with the arbitrage regulations.

DATES: Effective Date: These regulations are effective on March 1,

1999.

Applicability Date: These regulations are applicable to bonds sold

on or after March 1, 1999.

Issuers may apply these regulations to bonds sold on or after

December 30, 1998 and before March 1, 1999.

FOR FURTHER INFORMATION CONTACT: David White, 202-622-3980 (not a toll-

free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1490. Responses to these collections of information

are required to obtain the benefits of a safe harbor.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated annual burden per record keeper varies from .75 hour

to 2 hours, depending on individual circumstances, with an estimated

average of 1 hour.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of the Treasury, Office of Information

and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

These final regulations contain amendments to the income tax

regulations (26 CFR Part 1) under section 148 of the Internal Revenue

Code of 1986 (Code). Section 148 provides rules addressing the use of

proceeds of tax-exempt State and local bonds to acquire higher-yielding

investments. On June 18, 1993, final regulations (TD 8476) relating to

the arbitrage restrictions and related rules under sections 103, 148,

149, and 150 were published in the Federal Register (58 FR 33510).

Corrections to these regulations were published in the Federal Register

on August 23, 1993 (58 FR 44451), and May 11, 1994 (59 FR 24350).

On June 27, 1996, a notice of proposed rulemaking (FI-28-96)

relating to the arbitrage restrictions was published in the Federal

Register (61 FR 33405). The proposed regulations provide a rebuttable

presumption for establishing fair market value for United States

Treasury obligations that are purchased other than directly from the

United States Treasury. In addition, the proposed regulations provide a

rebuttable presumption that a solicitation that meets certain

requirements is a bona fide solicitation for the guaranteed investment

contract safe harbor of Sec. 1.148-5(d)(6)(iii). A public hearing was

held on Thursday, October 24, 1996, and written comments were received.

After consideration of all the comments, the regulations proposed by

FI-28-96 are, with modifications, adopted by revision to Sec. 1.148-

5(d)(6)(iii). The changes are discussed below.

Explanation of Provisions

A. In General

Due to concerns regarding the fair market purchase price of United

States Treasury obligations purchased other than directly from the

United States Treasury, the proposed regulations provide a rebuttable

presumption for establishing fair market value. The proposed

regulations generally apply the principles underlying the existing safe

harbor in the arbitrage regulations for establishing fair market value

for guaranteed investment contracts.

The proposed regulations also provide a rebuttable presumption that

a solicitation meeting the requirements of the proposed regulations

will be a bona fide solicitation for the guaranteed investment contract

safe harbor of existing Sec. 1.148-5(d)(6)(iii).

Modifications to the proposed regulations have been made to clarify

various technical aspects in response to comments received.

B. Safe Harbor

Commentators noted that a rebuttable presumption in the proposed

regulations for purchases of United States Treasury obligations

provides a lower level of protection to issuers than the safe harbor

applicable to guaranteed investment contracts. Commentators generally

requested that the final regulations provide a safe harbor for the

purchase of United States Treasury obligations.

The final regulations create a safe harbor for all investments

covered by the regulations, provided that the issuer receives at least

three bids as required by the regulations. The premise of the final

regulations is that a bidding procedure satisfying the requirements of

the final regulations will produce a price that equals fair market

value. If the requirements of the final regulations are not in fact

met, no assumption can be made about the relationship of the price paid

to fair market value. However, all reasonable and prudent actions taken

by the issuer under the circumstances may be considered in determining

whether the issuer paid fair market value.

[[Page 71749]]

C. Scope of Final Regulations

Generally, the proposed regulations apply to United States Treasury

obligations purchased other than directly from the United States

Treasury. Commentators requested clarification regarding the scope of

the proposed regulations and requested that the regulations only apply

to investments purchased for yield restricted refunding and yield

restricted sinking fund escrows. In addition, commentators asked that

the proposed regulations be expanded to apply to other types of

investments that may be purchased for an escrow (e.g., REFCORP strips).

The final regulations apply only to guaranteed investment contracts

and yield restricted defeasance escrows. With respect to yield

restricted defeasance escrows, the final regulations expand the scope

of investments covered by the proposed regulations to apply to all

investments purchased for the escrow (e.g., United States Agency

obligations, REFCORP strips and corporate obligations).

D. Guaranteed Investment Contracts

Commentators requested clarification regarding which investments

are covered by the safe harbor for guaranteed investment contracts and

which would be covered by the proposed regulations.

The term guaranteed investment contract generally does not include

investments purchased for a yield restricted defeasance escrow.

However, the term guaranteed investment contract does include escrow

float contracts and similar agreements purchased for a yield restricted

defeasance escrow. In addition, the term guaranteed investment contract

includes debt service fund forward agreements and debt service reserve

fund agreements (e.g., agreements to deliver United States Treasury

obligations over a period of time).

E. No Last Look

The proposed regulations state that all providers must have equal

opportunity to bid and that no provider is permitted to review other

bids before bidding (e.g., a last look). A small number of commentators

noted that the existence of a last look may result in higher yields

from competing providers. The final regulations retain the no last look

requirement because permitting a last look may adversely affect the

bona fides of the bidding process.

F. Reasonably Competitive Providers

The proposed regulations provide that all bidders are required to

be reasonably competitive providers of investments of the type being

purchased. Numerous comments were received regarding the meaning of the

phrase ``reasonably competitive provider,'' and commentators expressed

concern that a bid from a non-competitive provider may prevent the

requirements of the regulations from being satisfied.

The final regulations modify this provision. The final regulations

provide that the issuer must solicit at least three bids from

reasonably competitive providers and that the issuer must receive at

least one bid from a reasonably competitive provider. For purposes of

the final regulations, a reasonably competitive provider is a provider

that has an established industry reputation as a competitive provider

of the type of investments being purchased. For example, in connection

with the solicitation of bids for a guaranteed investment contract, an

entity that has an established industry reputation as a competitive

provider of guaranteed investment contracts is a reasonably competitive

provider.

G. No Material Financial Interest

The proposed regulations, like the existing safe harbor for

guaranteed investment contracts, provide that the issuer must receive

at least three bona fide bids from providers that have no material

financial interest in the issue. For this purpose, the proposed

regulations provide that underwriters and financial advisors for an

issue are considered to have a material financial interest. Numerous

comments were received regarding the scope of entities that are

considered to have a material financial interest under the proposed

regulations.

The final regulations clarify that, for purchases of any investment

covered by the safe harbor, the lead underwriter in a negotiated

underwriting transaction is deemed to have a material financial

interest in the issue until 15 days after the issue date of the issue.

Any entity acting as a financial advisor with respect to the purchase

of the investment at the time that the bid specification form is

submitted to potential providers is also deemed to have a material

financial interest in the issue. In addition, the final regulations

require the provider to represent that its bid is not based on any

other formal or informal agreement that the provider has with the

issuer or any other person. A provider that is a related party to a

provider that has a material financial interest in the issue is also

deemed to have a material financial interest in the issue.

H. Commercially Reasonable Terms

The proposed regulations provide that the terms of the purchase

agreement must be reasonable. The existing safe harbor for guaranteed

investment contracts provides that the terms of the guaranteed

investment contract, including the collateral security requirements,

must be reasonable. A number of commentators requested clarification

regarding what reasonable means in connection with a solicitation of

United States Treasury obligations.

The final regulations provide that the terms of the bid

specification for any investment covered by the safe harbor must be

commercially reasonable. A term is commercially reasonable if there is

a legitimate business purpose for including the term in the bid

specifications other than to lower the yield or increase the cost of

the bid. For example, in connection with the solicitation of

investments for a yield restricted defeasance escrow, a commercially

unreasonable term would be a hold firm period that is longer than the

issuer reasonably requires.

I. Comparison to State and Local Government Series Securities

The proposed regulations provide that the yield on any United

States Treasury obligation purchased by the issuer may not be less than

the yield then available on State and Local Government Series

Securities from the United States Department of the Treasury, Bureau of

Public Debt (SLGs) with the same maturity. Commentators requested that

the SLGs comparison be removed or that issuers be allowed to make the

comparison on a portfolio-by-portfolio basis. Commentators also

requested guidance about the time period in which the SLGs comparison

is to be made.

In general, the final regulations provide that the safe harbor does

not apply to investments purchased for a yield restricted defeasance

escrow if the lowest cost bid is greater than the cost of the most

efficient SLG portfolio. The final regulations provide that the lowest

cost bid is the lowest bid for the portfolio or, if the issuer compares

bids on an investment-by-investment basis, the aggregate cost of a

portfolio comprised of the lowest cost bid for each investment. Any

payment received by the issuer from a provider at the time a guaranteed

investment contract is purchased (e.g., an escrow float contract) for a

yield restricted defeasance escrow under a bidding procedure meeting

the requirements of the final regulations is taken into

[[Page 71750]]

account in determining the lowest cost bid.

The final regulations provide the following rules for comparing the

lowest cost bid to SLGs. First, the most efficient SLG portfolio

consists of one or more SLG securities that will allow the issuer to

defease the refunded obligations at the lowest overall cost. Second,

the comparison of the most efficient SLG portfolio and the lowest cost

bid must be made at the time that bids are required to be submitted

pursuant to the terms of the bid specifications. Intra-day pricing

movements and closing spot prices of investments before and after the

time in which the comparison to SLGs is required to be made are not

relevant. Third, if SLGs are not available for purchase on the day that

bids are required to be submitted pursuant to terms of the bid

specifications because Treasury has suspended sales of those

securities, the comparison of the most efficient SLG portfolio to the

lowest cost bid is not required.

No comparison to SLGs is required for purchases of guaranteed

investment contracts.

J. Forward Pricing Data

The proposed regulations provide that the yield on United States

Treasury obligations purchased by the issuer may not be significantly

less than the yield then available from the provider on reasonably

comparable United States Treasury obligations offered to other persons

for purchase on terms comparable to those offered to the issuer from a

source of funds other than tax-exempt bonds. If closely comparable

forward prices are not available, a reasonable basis for this

comparison may be by reference to implied forward prices for Treasury

obligations based on standard financial formulas. A certificate

provided by the agent conducting the bidding process will establish

that the comparison is met. The existing safe harbor for guaranteed

investment contracts provides that the yield on the guaranteed

investment contract may not be less than the yield then available from

the provider on reasonably comparable guaranteed investment contracts,

if any, offered to other persons from a source of funds other than

gross proceeds of tax-exempt bonds.

Commentators noted that, in general, the comparison required by the

proposed regulations is either too complex or not possible to

construct. In lieu of a comparability requirement, commentators

recommended that the regulations adopt certain additional safeguards to

protect the integrity of the bidding process.

The final regulations remove the comparability requirement for all

investments covered by the safe harbor. However, the final regulations

include additional requirements to ensure a competitive bidding

process. For example, the final regulations require that the bid form

forwarded to potential providers include a statement notifying

providers that by submitting a bid the potential provider is

representing that it did not consult with any other providers about

their bid, and that its bid is not being submitted solely as a courtesy

to the issuer or any other person for purposes of satisfying the

requirement that the issuer receive three bids. It is anticipated that

these additional requirements will ensure that the bids reflect fair

market value, as determined without regard to the source of funds.

K. Record Keeping Requirements

The proposed regulations provide that issuers are required to

retain certain records and information with the bond documents,

including a copy of the bids received (date and time stamped). Numerous

comments were received regarding the difficulty of obtaining written

bids for Treasury obligations.

The final regulations modify the record keeping requirements and

apply those requirements to guaranteed investment contracts. One

modification to the record keeping requirements is the elimination of

the requirement that the bids be received in writing. The final

regulations provide that the requirement for recording the bid is

satisfied if the issuer or its agent makes a contemporaneous record of

the bid, including the time and date each bid was received, and the

identification of the person and entity submitting the bid, and keeps

this record with the bond documents.

The final regulations also provide that, if the terms of the

purchase agreement deviate from the terms of the bid solicitation form

or if a submitted bid is modified, the issuer must keep a record

explaining the purpose of the deviation or modification and, if the

purchase agreement price differed from the bid, how that price was

determined. If the issuer replaces investments in the winning bid

portfolio with other investments, the prices of the new investments are

not protected by the safe harbor unless those investments are bid under

a bidding procedure meeting the requirements of the final regulations.

L. Broker Fees for Yield Restricted Defeasance Escrows

The proposed regulations provide that a fee paid to a bidding agent

is a qualified administrative cost only if the fee is comparable to a

fee that would be charged for a reasonably comparable investment of

obligations acquired with a source of funds other than gross proceeds

of tax-exempt bonds and the fee is reasonable. Under the proposed

regulations, the fee is presumed to be reasonable if it does not exceed

.02 percent of the amount invested in United States Treasury

obligations. Commentators noted that the comparability requirement was

unclear and that outside the context of municipal bonds, bidding for

closely comparable investments is virtually non-existent. Commentators

also noted that the .02 percent fee may result in too much compensation

in the case of large escrows and too little compensation in the case of

small escrows.

The final regulations retain the comparability and reasonableness

requirements. However, the final regulations provide that a broker's

fee will meet the reasonableness and comparability requirements if the

fee does not exceed the lesser of $10,000 or .1 percent of the initial

principal amount of investments purchased for the yield restricted

defeasance escrow.

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 is hereby certified that

these regulations do not have a significant economic impact on a

substantial number of small entities. This certification is based upon

the fact that the amount of time required to meet the record keeping

requirement of these final regulations, an estimated annual average of

1 hour per taxpayer, is small. Also, the regulations affect a small

number of taxpayers, approximately 1400 annually. Therefore, a

Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5

U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the

Internal Revenue Code, the notice of proposed rulemaking preceding

these regulations was submitted to the Small Business Administration

for comment on its impact on small business.

Drafting information. The principal authors of these regulations

are David White and Rebecca Harrigal of the IRS Office of Chief Counsel

and Edwin G. Oswald of the Department of the Treasury. However, other

personnel from the IRS and the Treasury Department participated in

their development.

[[Page 71751]]

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 1.148-5 is amended as follows:

1. Paragraph (d)(6)(iii) is revised.

2. Paragraph (e)(2)(iv) is added.

The revision and addition read as follows:

Sec. 1.148-5 Yield and valuation of investments.

* * * * *

(d) * * *

(6) * * *

(iii) Safe harbor for establishing fair market value for guaranteed

investment contracts and investments purchased for a yield restricted

defeasance escrow. The purchase price of a guaranteed investment

contract and the purchase price of an investment purchased for a yield

restricted defeasance escrow will be treated as the fair market value

of the investment on the purchase date if all of the following

requirements are satisfied:

(A) The issuer makes a bona fide solicitation for the purchase of

the investment. A bona fide solicitation is a solicitation that

satisfies all of the following requirements:

(1) The bid specifications are in writing and are timely forwarded

to potential providers.

(2) The bid specifications include all material terms of the bid. A

term is material if it may directly or indirectly affect the yield or

the cost of the investment.

(3) The bid specifications include a statement notifying potential

providers that submission of a bid is a representation that the

potential provider did not consult with any other potential provider

about its bid, that the bid was determined without regard to any other

formal or informal agreement that the potential provider has with the

issuer or any other person (whether or not in connection with the bond

issue), and that the bid is not being submitted solely as a courtesy to

the issuer or any other person for purposes of satisfying the

requirements of paragraph (d)(6)(iii)(B)(1) or (2) of this section.

(4) The terms of the bid specifications are commercially

reasonable. A term is commercially reasonable if there is a legitimate

business purpose for the term other than to increase the purchase price

or reduce the yield of the investment. For example, for solicitations

of investments for a yield restricted defeasance escrow, the hold firm

period must be no longer than the issuer reasonably requires.

(5) For purchases of guaranteed investment contracts only, the

terms of the solicitation take into account the issuer's reasonably

expected deposit and drawdown schedule for the amounts to be invested.

(6) All potential providers have an equal opportunity to bid. For

example, no potential provider is given the opportunity to review other

bids (i.e., a last look) before providing a bid.

(7) At least three reasonably competitive providers are solicited

for bids. A reasonably competitive provider is a provider that has an

established industry reputation as a competitive provider of the type

of investments being purchased.

(B) The bids received by the issuer meet all of the following

requirements:

(1) The issuer receives at least three bids from providers that the

issuer solicited under a bona fide solicitation meeting the

requirements of paragraph (d)(6)(iii)(A) of this section and that do

not have a material financial interest in the issue. A lead underwriter

in a negotiated underwriting transaction is deemed to have a material

financial interest in the issue until 15 days after the issue date of

the issue. In addition, any entity acting as a financial advisor with

respect to the purchase of the investment at the time the bid

specifications are forwarded to potential providers has a material

financial interest in the issue. A provider that is a related party to

a provider that has a material financial interest in the issue is

deemed to have a material financial interest in the issue.

(2) At least one of the three bids described in paragraph

(d)(6)(iii)(B)(1) of this section is from a reasonably competitive

provider, within the meaning of paragraph (d)(6)(iii)(A)(7) of this

section.

(3) If the issuer uses an agent to conduct the bidding process, the

agent did not bid to provide the investment.

(C) The winning bid meets the following requirements:

(1) Guaranteed investment contracts. If the investment is a

guaranteed investment contract, the winning bid is the highest yielding

bona fide bid (determined net of any broker's fees).

(2) Other investments. If the investment is not a guaranteed

investment contract, the following requirements are met:

(i) The winning bid is the lowest cost bona fide bid (including any

broker's fees). The lowest cost bid is either the lowest cost bid for

the portfolio or, if the issuer compares the bids on an investment-by-

investment basis, the aggregate cost of a portfolio comprised of the

lowest cost bid for each investment. Any payment received by the issuer

from a provider at the time a guaranteed investment contract is

purchased (e.g., an escrow float contract) for a yield restricted

defeasance escrow under a bidding procedure meeting the requirements of

this paragraph (d)(6)(iii) is taken into account in determining the

lowest cost bid.

(ii) The lowest cost bona fide bid (including any broker's fees) is

not greater than the cost of the most efficient portfolio comprised

exclusively of State and Local Government Series Securities from the

United States Department of the Treasury, Bureau of Public Debt. The

cost of the most efficient portfolio of State and Local Government

Series Securities is to be determined at the time that bids are

required to be submitted pursuant to the terms of the bid

specifications.

(iii) If State and Local Government Series Securities from the

United States Department of the Treasury, Bureau of Public Debt are not

available for purchase on the day that bids are required to be

submitted pursuant to terms of the bid specifications because sales of

those securities have been suspended, the cost comparison of paragraph

(d)(6)(iii) (C)(2)(ii) of this section is not required.

(D) The provider of the investments or the obligor on the

guaranteed investment contract certifies the administrative costs that

it pays (or expects to pay, if any) to third parties in connection with

supplying the investment.

(E) The issuer retains the following records with the bond

documents until three years after the last outstanding bond is

redeemed:

(1) For purchases of guaranteed investment contracts, a copy of the

contract, and for purchases of investments other than guaranteed

investment contracts, the purchase agreement or confirmation.

(2) The receipt or other record of the amount actually paid by the

issuer for the investments, including a record of

[[Page 71752]]

any administrative costs paid by the issuer, and the certification

under paragraph (d)(6)(iii)(D) of this section.

(3) For each bid that is submitted, the name of the person and

entity submitting the bid, the time and date of the bid, and the bid

results.

(4) The bid solicitation form and, if the terms of the purchase

agreement or the guaranteed investment contract deviated from the bid

solicitation form or a submitted bid is modified, a brief statement

explaining the deviation and stating the purpose for the deviation. For

example, if the issuer purchases a portfolio of investments for a yield

restricted defeasance escrow and, in order to satisfy the yield

restriction requirements of section 148, an investment in the winning

bid is replaced with an investment with a lower yield, the issuer must

retain a record of the substitution and how the price of the substitute

investment was determined. If the issuer replaces an investment in the

winning bid portfolio with another investment, the purchase price of

the new investment is not covered by the safe harbor unless the

investment is bid under a bidding procedure meeting the requirements of

this paragraph (d)(6)(iii).

(5) For purchases of investments other than guaranteed investment

contracts, the cost of the most efficient portfolio of State and Local

Government Series Securities, determined at the time that the bids were

required to be submitted pursuant to the terms of the bid

specifications.

(e) * * *

(2) * * *

(iv) Special rule for investments purchased for a yield restricted

defeasance escrow. For investments purchased for a yield restricted

defeasance escrow, a fee paid to a bidding agent is a qualified

administrative cost only if the following requirements are satisfied:

(A) The fee is comparable to a fee that would be charged for a

reasonably comparable investment if acquired with a source of funds

other than gross proceeds of tax-exempt bonds, and it is reasonable.

The fee is deemed to be comparable to a fee that would be charged for a

comparable investment acquired with a source of funds other than gross

proceeds of tax-exempt bonds, and to be reasonable if the fee does not

exceed the lesser of $10,000 or .1% of the initial principal amount of

investments deposited in the yield restricted defeasance escrow.

(B) For transactions in which a guaranteed investment contract and

other investments are purchased for a yield restricted defeasance

escrow in a single investment (e.g., an issuer bids United States

Treasury obligations and an escrow float contract collectively), a

broker's fee described in paragraph (e)(2)(iv)(A) of this section will

apply to the initial principal amount of the investment deposited in

the yield restricted defeasance escrow, and a broker's fee described in

paragraph (e)(2)(iii) of this section will apply only to the guaranteed

investment contract portion of the investment.

* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 4. In Sec. 602.101, paragraph (c) is amended by revising the

entry for 1.148-5 in the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control No.

------------------------------------------------------------------------

* * * * *

1.148-5................................................. 1545-1098,

1545-1490

* * * * *

------------------------------------------------------------------------

Approved: December 17, 1998.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 98-34209 Filed 12-29-98; 8:45 am]

BILLING CODE 4830-01-U