Rev. Rul. 80-188

ISSUE

Will bonds that have been issued by an authority that is a political subdivision of a state be arbitrage bonds within the meaning of section 103(c)(2) of the Internal Revenue Code under the circumstances described below?

FACTS

Authority M is a hospital district that is a political subdivision of the state of O. On January 2, 1976, M issued its advance refunding bonds to refund construction bonds that were issued by M in 1975. The refunding bonds have a yield of 8 percent.

A major portion of the proceeds of the advance refunding bonds were immediately invested in United States Treasury obligations--State and Local Government Series (SLGS) at a restricted yield of 8 percent. Amounts representing a minor portion of the proceeds of the advance refunding bonds were immediately invested in SLGS at an unrestricted yield of 9 percent.

On February 4, 1980, M redeemed the SLGS that it had purchased in 1976 and used the proceeds to purchase United States Treasury bonds. M invested a minor portion of the proceeds of the redemption in United States Treasury bonds at an unrestricted yield. M invested part of the major portion of the proceeds of the redemption in United States Treasury bonds at a yield of 13 percent. M invested the remainder of the major portion of the proceeds of the redemption in United States Treasury bonds with a maturity date of February 1, 1980. M purchased all of the Treasury bonds at fair market value from A, an unrelated third person.

M directed the trustee for the advance refunding bonds not to redeem the Treasury bonds that matured on February 1, 1980, until five years had elapsed from the purchase of such bonds. In computing the yield on its major portion investments, M took into account the yield on the matured Treasury bonds as of the date the bonds would be presented for payment. As computed by M, the yield on all the Treasury bonds allocated to the major portion of the advance refunding bonds is 8 percent.

M allocated all of the costs of the purchase of the Treasury bonds to the minor portion of the escrow for the advance refunding bonds. At the time of the issuance of the advance refunding bonds M executed a no-arbitrage certification in accordance with the provisions of section 1.103-13(a)(2)(ii) of the proposed Income Tax Regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944).

LAW AND ANALYSIS

Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state or a political subdivision of a state.

Section 103(c)(1) of the Code provides that, with certain minor exceptions, the interest on any arbitrage bond will not be excludable from gross income.

Section 103(c)(2) of the Code provides that the term "arbitrage bond" means any obligation that is issued as part of an issue 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 reasonably expected at the time of issuance of such issue, to produce a yield over the term of the issue that is materially higher than the yield on obligations of such issue, or (B) to replace funds that were used directly or indirectly to acquire securities or obligations described in section 103(c)(2)(A).

T.D. 7627 (44 F.R. 32657), 1979-2 C.B. 45, which adopted the final arbitrage bond regulations, provides that, for governmental obligations issued on or before the effective date of the final regulations (May 31, 1979), the proposed income tax regulations, as amended, under section 103(c) of the Code shall apply.

Section 1.103-13(a)(2)(i) of the proposed regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944), provides, in part, that under section 103(c)(2) of the Code the determination whether an obligation is an arbitrage bond depends upon the issuer's reasonable expectations, as of the date of issue, regarding the amount and use of the proceeds of the issue. The reasonable expectations regarding the amount and use of the proceeds of a governmental obligation may be established by the certification described in section 1.103-13(a)(2)(ii).

Example (1) of section 1.103-13(a)(2)(v) of the final regulations illustrates the effect of a no-arbitrage certification. In this example, city A issues bonds to construct a water treatment facility and in the certification A includes a statement that 85 percent of the receipts from the sale of the bonds will be used for construction costs within three years of the date of issue of the bonds. Subsequently, construction of the water treatment facility was determined by the Environmental Protection Agency to have certain adverse effects. As a result, 85 percent of the receipts from the sale of the bonds will not be expended for project costs within three years of the date of issue of the bonds. The example concludes that the certification is conclusive as to the issuer's reasonable expectations that 85 percent of the receipts will be expended for construction costs within three years of the date of issue of the bonds.

Section 1.103-13(b)(4)(i) of the proposed regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944), provides that the term "acquired obligations" means securities and obligations allocated to the proceeds of an issue of governmental obligations during the period of time such issue is outstanding.

Section 1.103-13(b)(4)(iii) of the proposed regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944), provides that the term "obligation" means any evidence of indebtedness that is not described in section 103(a)(1) of the Code. An amendment to section 1.103-13(b)(4)(iii), published in the Federal Register of October 29, 1976 (41 F.R. 47680), provides that cash is not an acquired obligation. For example, cash held or received by a trustee is not taken into account as a zero-yield obligation for the period that it is held before being invested in an acquired obligation or for the period that it is held after repayment of an obligation and before being reinvested in an acquired obligation.

Section 1.103-13(b)(5) of the proposed regulations published in the Federal Register of December 3, 1975 (40 F.R. 56448), provides, in part, that in the case of a refunding issue the yield produced by acquired obligations allocated to the proceeds (other than transferred proceeds) of the refunding issue is materially higher than the yield produced by such issue if the yield of such acquired obligations exceeds the yield of such issue.

The only reason M directed the trustee not to redeem the matured Treasury bonds at their face amount on the date they were purchased was to reduce the yield on the major portion of the bond proceeds. Therefore, for purposes of section 1.103-13(b)(4)(iii) of the proposed and final regulations the matured Treasury bonds purchased by M are considered paid and are the equivalent of cash. Accordingly, the yield on the matured Treasury bonds purchased by M may not be taken into account in computing the yield on the major portion investments for its advance refunding bonds. As a result, the yield on the major portion investments for M's advance refunding bonds is 13 percent.

The "reasonable expectations" test contained in section 103(c) of the Code and the certification procedure contained in section 1.103-13(a)(2) of the proposed and the final regulations both provide a high degree of certainty by generally assuring that the bonds will not be arbitrage bonds in the event of occurrences that are beyond the control of the issuer. Compare example (1) of section 1.103-13(a)(2)(v) of the final regulations which concerns the reasonable expectations of an issuer with respect to a matter it did not reasonably expect to occur and was beyond its control. However, neither the reasonable expectations test nor the certification procedure provides protection in this particular case where the issuer has taken deliberate and intentional actions to produce arbitrage.

HOLDING

M has failed to comply with the arbitrage yield restrictions of section 1.103-13(b)(5) of the proposed regulations. The no-arbitrage certification made by M will not prevent the advance refunding bonds from being arbitrage bonds. Thus, the advance refunding bonds issued by M are arbitrage bonds within the meaning of section 103(c)(2) of the Code and the interest on the bonds is not excludable from the gross income of the bondholders under section 103(a)(1).