Arbitrage and Related Restrictions Applicable to Tax-Exempt Bonds Issued by State and Local Governments; Investment-Type Property

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-113526-98]

RIN 1545-AW44

Arbitrage and Related Restrictions Applicable to Tax-Exempt Bonds

Issued by State and Local Governments; Investment-Type Property

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

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

and local governments. The proposed amendments affect issuers of tax-

exempt bonds and provide guidance on the definition of investment-type

property to help issuers comply with the arbitrage and related

restrictions.

DATES: Written comments must be received by December 23, 1999. Outlines

of topics to be discussed at the public hearing scheduled for January

12, 2000, at 10 a.m. must be received by December 15, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-113526-98), 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-

113526-98), 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

room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Barbara Jane League, (202) 622-3980; concerning submissions of

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

access list to attend the hearing, LaNita Van Dyke, (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 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), May 11, 1994 (59 FR

24350), and July 9, 1999 (64 FR 37037). On May 9, 1997, additional

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). This document proposes to modify

Sec. 1.148-1(e) to clarify which prepayments are investment-type

property under section 148(b)(2)(D).

Explanation of Provisions

The current regulations, at Sec. 1.148-1(e)(2), provide that

prepayments for property or services give rise to investment-type

property if a principal purpose for prepaying is to obtain an

investment return from the time that the payment is made until the time

that payment otherwise would be made. A prepayment does not give rise

to investment-type property if (1) 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

(2) prepayments on

[[Page 46321]]

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.

Recently, an issue arose about whether investment-type property

includes the prepayment of a contract for property or services after

the date that the contract is entered into. In City of Columbus v.

Commissioner, 112 F.3d 1201 (D.C. Cir. 1997), the court held that a

prepayment for property cannot occur after the property is acquired.

The court's holding suggests that an issuer could avoid investment-type

property by entering into a contract for property or services and, at a

later date, prepaying that contract. This result is inconsistent with

the intent of section 148. The legislative history indicates that

Congress intended that the arbitrage rules apply broadly. For example,

the Conference Report to the Tax Reform Act of 1986 provides that

investment property includes the acquisition of any property held for

investment (other than another tax-exempt bond). H.R. Conf. Rep. No.

841, 99th Cong., 2d Sess. II-747, 1986-3 C.B. (Vol. 4) 747.

This document proposes modifications to the regulations to

establish that prepayments that give rise to investment-type property

can occur after the contract for property or services is entered into

and to make other non-substantive, clarifying changes. It is intended

that these regulations address only the potential issue created by the

City of Columbus opinion as noted above. Comments are requested on

whether the affect of the changes proposed in this document is broader

than intended.

In addition to comments on the proposed regulations, comments are

requested on whether additional guidance is needed to clarify other

aspects of the investment-type property definition. For example,

comments are requested on whether clarification is needed on which

prepayments of an obligation will be treated as a prepayment for

property or services that gives rise to investment-type property, and

whether a contract under which property or services are to be provided

over time and the payments for those property or services are to be

made over time gives rise to investment-type property when the payment

schedule does not match the schedule for the provision of the property

or services.

Finally, Treasury and the IRS have become aware of certain

transactions involving prepayments for the purchase of a commodity. In

these transactions, an issuer generally enters into a long-term

contract with a supplier (for example, a natural gas supply company) to

supply over a number of years a fixed amount of the commodity to the

issuer at a fixed price (the ``supply contract''). In return, the

issuer makes a single lump-sum prepayment for the commodity to the

supplier. The prepayment is financed through the issuance of bonds. The

amount of the prepayment is determined in a manner that permits the

issuer to obtain an investment return from the prepayment. The issuer

also enters into other agreements, including one or more swap

agreements, that result in the issuer converting substantially all of

the issuer's cost for the commodity under the supply contract into a

variable cost that approximates the then current price of the commodity

when the issuer takes delivery.

Based on the information received, and viewing the transaction as a

whole, it appears that a principal purpose of the prepayment for the

supply contract was to earn an investment return. If so, the supply

contract is investment-type property unless the requirement of

Sec. 1.148-1(e)(2)(i) or (ii) are met. Treasury and the IRS are

concerned that the supply contract may be investment-type property and

request comments on these transactions.

The regulations, when finalized, will apply to bonds issued after a

date of applicability that will be set forth in the final regulations.

Treasury and the IRS have not yet determined such date of applicability

other than to have made the determination that the date of

applicability will not be before this document is August 25, 1999.

Treasury and the IRS request comments as to the date of applicability

of the final regulations. No inference is intended as to the treatment

of bonds issued prior to the date of applicability of the 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 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 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 Wednesday, January 12,

2000, beginning at 10 a.m. in room 2615, 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 December 23, 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 December 15, 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 Rebecca L.

Harrigal and Barbara Jane League, 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.

[[Page 46322]]

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 1.148-1(e) is amended as follows:

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

2. Paragraphs (e)(2) introductory text, (e)(2)(i) and (e)(2)(ii)

are redesignated as paragraphs (e)(2)(i) introductory text,

(e)(2)(i)(A), and (e)(2)(i)(B), respectively.

3. Paragraph (e)(2) heading is revised.

4. Newly designated paragraph (e)(2)(i) introductory text is

revised.

5. New paragraph (e)(2)(ii) is added.

The revisions and addition 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. For this purpose,

production of income includes any benefit based on the time value of

money.

(2) Prepayments. (i) Except as otherwise provided in this paragraph

(e), a prepayment for property or services, including a prepayment of a

contract for property or services that is made after the date that the

contract is entered into, also gives rise to 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 does not give rise to investment type

property if--

* * * * *

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

paragraph (e)(2)(i) of this section:

Example. In 1996, City A entered into a ten-year contract with

Company Y. Under the contract, Company Y is to provide services to

City A and in return City A will make fixed annual payments to

Company Y. In 1998, Company Y and City A agree that City A will

prepay its obligation under the contract. To finance the prepayment,

City A will issue bonds. The amount of the prepayment is determined

in a manner that permits City A to obtain an investment return from

the prepayment. A principal purpose for City A agreeing to make the

prepayment is to obtain an investment return from the time of the

prepayment until the time payment otherwise would be made. The

prepayment is not made for a substantial business purpose other than

to obtain the investment return and City A had a commercially

reasonably alternative to the prepayment. In addition, prepayments

on substantially the same terms are not made by a substantial

percentage of persons who are similarly situated to City A but who

are not beneficiaries of tax-exempt financing. When the prepayment

is made, City A will have acquired investment-type property. It does

not matter that the prepayment occurred after the date that the

contract was entered into.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-21878 Filed 8-24-99; 8:45 am]

BILLING CODE 4830-01-P