Arbitrage Restrictions Applicable to Tax-Exempt Bonds Issued by State and Local Governments

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105565-99]

RIN 1545-AX22

Arbitrage Restrictions Applicable to Tax-Exempt Bonds Issued by

State and Local Governments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations on the arbitrage

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

governments. The proposed amendments affect issuers of tax-exempt bonds

and provide a safe harbor for qualified administrative costs for

brokers' commissions and similar fees incurred in connection with the

acquisition of a guaranteed investment contract or investments

purchased for a yield restricted defeasance escrow.

DATES: Written comments must be received by November 26, 1999.

Outlines of topics to be discussed at the public hearing scheduled

for December 14, 1999, at 10 a.m. must be received by Tuesday, November

23, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-105565-99), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG-

105565-99), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS site at http://www.irs.ustreas.gov/tax__regs/regslist.html. The

public hearing is in the Auditorium, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Rose M. Weber, (202) 622-3980; concerning submissions of comments, the

hearing, and/or requests to be placed on the building access list to

attend the hearing, Michael Slaughter, (202) 622-7180 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 148 of the Internal Revenue Code provides rules addressing

the use of proceeds of tax-exempt State and local bonds to acquire

higher-yielding investments. On May 9, 1997, final regulations (TD

8718) relating to the arbitrage restrictions and related rules under

sections 103, 148, 149, and 150 were published in the Federal Register

(62 FR 25502). The final regulations (TD 8718) were amended on December

30, 1998 (63 FR 71748). This document proposes to modify Sec. 1.148-

5(e)(2) to provide a safe harbor for determining whether brokers'

commissions and similar fees incurred in connection with the

acquisition of guaranteed investment contracts or investments purchased

for a yield restricted defeasance escrow are treated as qualified

administrative costs.

Explanation of Provisions

Section 1.148-5(e)(2)(iii) and (iv) of the regulations provides

rules for determining whether a broker's commission or similar fee is

treated as a qualified administrative cost. Section 1.148-5(e)(2)(iii)

provides that, for a guaranteed investment contract, a broker's

commission or similar fee paid on behalf of either an issuer or the

provider is treated as an administrative cost and, generally, is a

qualified administrative cost to the extent that the present value of

the commission, as of the date the contract is allocated to the issue,

does not exceed the lesser of a reasonable amount or the present value

of annual payments equal to .05 percent of the weighted average amount

reasonably expected to be invested each year of the term of the

contract. Present value is computed using the taxable discount rate

used by the parties to compute the commission, or if not readily

ascertainable, the yield to the issuer on the investment contract or

other reasonable taxable discount rate.

Section 1.148-5(e)(2)(iv) provides that, for investments purchased

for a yield restricted defeasance escrow, a fee paid to a bidding agent

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

fee that would be

[[Page 46877]]

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 meet both the comparability and

reasonableness requirements if it does not exceed the lesser of $10,000

and .1 percent of the initial principal amount of investments deposited

in the yield restricted defeasance escrow.

Unlike Sec. 1.148-5(e)(2)(iv), Sec. 1.148-5(e)(2)(iii) does not

provide parameters under which the reasonableness test will be deemed

to have been met. Practitioners have noted that they are uncertain

about how to determine reasonableness and whether the .05% test may be

used as a safe harbor without regard to whether the resulting amount is

a reasonable fee.

Practitioners have also noted that the computation required by

Sec. 1.148-5(e)(2)(iii) is too complex and results in different fees

being paid for the same services provided.

Finally, having different rules for guaranteed investment contracts

and investments purchased for a yield restricted defeasance escrow

provides an unnecessary tax incentive to structure investments in a

certain manner.

To eliminate these complexities and to provide a rule that is

easily administered by issuers, the proposed regulations create a

single rule for qualified administrative costs that applies to a

broker's commission or similar fee incurred in connection with a

guaranteed investment contract or investments purchased for a yield

restricted defeasance escrow. The proposed regulations also set forth a

safe harbor, which allows a broker's commission or similar fee incurred

in connection with the acquisition of a guaranteed investment contract

or investments purchased for a yield restricted defeasance escrow to be

treated as a qualified administrative cost. To fairly compensate most

brokers, the proposed safe harbor provides a higher safe harbor limit

than is currently provided for in Sec. 1.148-5(e)(2)(iv).

The proposed safe harbor sets forth two requirements. Under the

first requirement, the amount of the broker's commission or similar fee

incurred in connection with the acquisition of a guaranteed investment

contract or other investments purchased for a yield restricted

defeasance escrow and treated by the issuer as a qualified

administrative cost cannot exceed the lesser of $25,000 and .2 percent

of the computational base. For guaranteed investment contracts, the

computational base is the aggregate amount reasonably expected to be

deposited over the term of the contract. For investments, other than

guaranteed investment contracts, deposited in a yield restricted

defeasance escrow, the computational base is the initial amount

invested in those investments. For example, for a guaranteed investment

contract purchased for a debt service fund, the aggregate amount

reasonably expected to be deposited includes all periodic deposits

reasonably expected to be made pursuant to the terms of the contract.

Under the second requirement, for any issue of bonds, the issuer cannot

treat as qualified administrative costs more than $75,000 in brokers'

commissions and similar fees with respect to all guaranteed investment

contracts and investments for yield restricted defeasance escrows

purchased with gross proceeds of the issue.

The proposed regulations eliminate the special rule in Sec. 1.148-

5(e)(2)(iii) for issues that meet section 148(f)(4)(D)(i). These bond

issues will be permitted to use the safe harbor.

These regulations are proposed to apply to bonds sold on or after

the date 90 days after the issuance of the final regulations.

Special Analysis

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 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, 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 electronic and written comments (a

signed original and eight (8) copies, if written) that are submitted

timely to the IRS. In particular, the IRS and Department of Treasury

specifically request comments on the clarity of the proposed rule and

how it may be made easier to understand. All comments will be available

for public inspection and copying.

A public hearing has been scheduled for Tuesday, December 14, 1999,

beginning at 10 a.m. in the IRS Auditorium, Internal Revenue Building,

1111 Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who

wish to present oral comments at the hearing must submit written

comments by November 26, 1999, and submit an outline of the topics to

be discussed and the time to be devoted to each topic (signed original

and eight (8) copies) by November 23, 1999. A period of 10 minutes will

be allotted to each person for making comments. An agenda showing the

scheduling of speakers will be prepared after the deadline for

receiving outlines has passed. Copies of the agenda will be available

free of charge at the hearing.

Drafting Information

The principal authors of these proposed regulations are Rose M.

Weber and Rebecca L. Harrigal, Office of the Assistant Chief Counsel

(Financial Institutions & 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. In Sec. 1.148-5, paragraph (e) is amended as follows:

1. Paragraph (e)(2)(iii) is revised.

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

The revision reads as follows:

[[Page 46878]]

Sec. 1.148-5 Yield and valuation of investments.

* * * * *

(e) * * *

(2) * * *

(iii) Special rule for guaranteed investment contracts and

investments purchased for a yield restricted defeasance escrow--(A) In

general. An amount paid for a broker's commission or similar fee with

respect to a guaranteed investment contract or investments purchased

for a yield restricted defeasance escrow is a qualified administrative

cost if the fee is reasonable within the meaning of paragraph (e)(2)(i)

of this section.

(B) Safe harbor. (1) A broker's commission or similar fee with

respect to the acquisition of a guaranteed investment contract or

investments purchased for a yield restricted defeasance escrow is

reasonable within the meaning of paragraph (e)(2)(i) of this section

if--

(i) The amount of the fee that the issuer treats as a qualified

administrative cost does not exceed the lesser of $25,000 and .2% of

the computational base; and

(ii) For any issue, the issuer does not treat as qualified

administrative costs more than $75,000 in brokers' commissions or

similar fees with respect to all guaranteed investment contracts and

investments for yield restricted defeasance escrows purchased with

gross proceeds of the issue.

(2) For purposes of paragraph (e)(2)(iii)(B)(1) of this section,

computational base shall mean--

(i) For a guaranteed investment contract, the amount the issuer

reasonably expects as of the issue date to be deposited in the

guaranteed investment contract over the term of the contract; and

(ii) For investments (other than guaranteed investment contracts)

to be deposited in a yield restricted defeasance escrow, the amount of

gross proceeds initially invested in those investments.

(C) Example. The following example illustrates an application of

the safe harbor in paragraph (e)(2)(iii)(B) of this section:

Example. The issuer of a multipurpose issue uses brokers to

purchase the following investments with gross proceeds of the issue:

a guaranteed investment contract for amounts to be deposited in a

debt service fund (debt service GIC), a guaranteed investment

contract for amounts to be deposited in a construction fund

(construction GIC), Treasury securities to be deposited in a yield

restricted defeasance escrow (Treasury investments) and a guaranteed

investment contract that will be used to earn a return on what would

otherwise be idle cash balances from maturing investments in the

yield restricted defeasance escrow (the float GIC). The issuer uses

$8,040,000 of the proceeds to purchase the Treasury investments and

deposits $14,000,000 into the construction GIC. Over the term of the

construction GIC, the issuer reasonably expects that no further

deposits will be made. Over the term of the float GIC, the issuer

reasonably expects that aggregate deposits of $600,000 will be made

to the float GIC. Over the term of the debt service GIC, the issuer

reasonably expects that it will make aggregate deposits of

$22,000,000, plus interest on the bond issue. The brokers' fees do

not exceed $16,080 for the Treasury investments, $25,000 for the

construction GIC, $1,200 for the float GIC, and $25,000 for the debt

service GIC. Assuming the issuer claims no further brokerage or

similar fees, the issuer can claim all $67,280 in brokerage fees for

these investments as qualified administrative costs because the fees

do not exceed the limitations described in paragraph (e)(2)(iii)(B)

of this section.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-21877 Filed 8-26-99; 8:45 am]

BILLING CODE 4830-01-P