Rev. Rul. 78-348

Will certain securities pledged as collateral for municipal bonds be subject to arbitrage yield restrictions?

FACTS

Situation 1.

State A proposes to sell $1 million of general obligation bonds, the proceeds of which will be loaned to Corporation B, a nonprofit corporation, that will use the proceeds to construct a hospital. In addition, B owns a federally insured mortgage note worth $1 million that will be pledged as collateral for the bonds. Under the terms of the pledge, the bondholders are reasonably assured that this collateral will be available if needed to pay debt service, even if A and B encounter financial difficulties. The yield on the mortgage note will be materially higher than the yield on the bonds.

Situation 2.

County C, a political subdivision of State D, proposes to sell $50 million of general obligation bonds. C will use the bond proceeds to finance the construction of various county buildings. Taxes and other revenues will be used to retire the bonds serially over 25 years.

D has a surplus fund that will be invested in Treasury bonds. Certain Treasury bonds worth $50 million will be pledged as collateral for C's bonds. Under the terms of the pledge, D cannot dispose of any of the Treasury bonds while C's bonds are outstanding (except to pay holders of the bonds in the case of default). Thus, the bondholders are reasonably assured that this collateral will be available if needed to pay debt service, even if C or D encounter financial difficulties. However, D does not reasonably expect to use the Treasury bonds (or interest thereon) directly or indirectly to pay debt service (payment of principal or interest) on C's bonds. The yield on the Treasury bonds will be materially higher than the yield on C's bonds.

LAW AND ANALYSIS

Section 103(c)(2) of the Internal Revenue Code of 1954 provides that the term "arbitrage bond" means any obligation all or a major portion (more than 15 percent) of the proceeds of which are reasonably expected to be used directly or indirectly (A) to acquire securities or obligations that may be expected to produce a yield over the term of the governmental issue that is materially higher than the yield on such issue; or (B) to replace funds that were used directly or indirectly to acquire securities or obligations described in (A).

Section 103(c)(2)(B) of the Code applies to an issue of obligations if the proceeds are used to replace funds invested in securities having a yield that is materially higher than the yield on the obligations. This section does not apply in every case in which the higher-yielding securities could have been liquidated as an alternative to issuing the bonds. However, the requisite nexus or sufficiently direct relationship between the bonds and the higher-yielding securities does exist where the securities are pledged as collateral for the bonds. An issuer that borrows to invest in higher-yielding securities and one that borrows against such securities already owned are in virtually the same economic position. Compare section 265(2) relating to interest paid to earn tax-exempt income, and see especially section 3.03 of Rev. Proc. 72-18, 1972-1 C.B. 740, citing Wisconsin Cheeseman v. United States, 338 F.2d 420 (7th Cir. 1968). The same principles apply when the higher-yielding securities pledged are held by any third party who will substantially benefit from the bond issuance.

For purposes of section 103(c)(2)(B) of the Code, a pledge of collateral need not be cast in a particular legal form. Thus, for example, the bondholders need not take actual or constructive possession of the collateral. However, there must be a reasonable assurance that the collateral will be available if needed to pay debt service, even if the issuer encounters financial difficulties. Thus, for example, an arrangement will not have the effect of a pledge of collateral if the issuer has discretion to defeat the "pledge" merely by liquidating the "collateral" and disposing of the proceeds.

In both Situations 1 and 2, securities (the federally insured mortgage note and the $50 million of Treasury bonds) are pledged as collateral for municipal bonds. Moreover, the yield on these securities is materially higher than the yield on the municipal bonds. Therefore, all or a major portion of the proceeds of the proposed bonds are reasonably expected to be used directly or indirectly to replace funds that were used to acquire securities at a materially higher yield.

HOLDING

The securities to be pledged as collateral for the proposed bonds described in Situations 1 and 2 will be subject to the arbitrage yield restrictions as provided by section 103(c) of the Code. Because the securities pledged as collateral will produce a yield materially higher than the yield on the bonds, the bonds (in both Situations 1 and 2) will be arbitrage bonds and the interest received by bondholders will not be excludable from their gross income under section 103(a)(1). Further, in Situation 1, the hospital bonds will be arbitrage bonds even if they are issued to finance the construction of a for-profit hospital.

¹ Also released as News Release IR-2028, dated August 23, 1978.