Rev. Rul. 80-92

ISSUE

Will an authority that is a political subdivision of a state comply with the arbitrage yield restrictions of section 103(c) of the Internal Revenue Code with respect to an issue of its obligations in the situation described below?

FACTS

Authority Q is a school district that is a political subdivision of the state of R. On January 2, 1976, Q issued its advance refunding bonds to refund construction bonds that were issued by Q 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 January 2, 1980, Q redeemed the SLGS that it had purchased in 1976. Q used the proceeds of the redemption to purchase United States Treasury bonds with an interest rate of 8 percent from S, an unrelated third person.

At par value the Treasury bonds have a yield of 8 percent. However, Q acquired the Treasury bonds at a time when their fair market value was below par. At fair market value, the yield on the Treasury bonds is 13 percent. Although Q knew the fair market value of the bonds, Q purchased a portion of the Treasury bonds at par. Q allocated the purchases at par to the major portion and computed the yield on those Treasury bonds by taking into account as the purchase price the par value of the Treasury bonds.

Q 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 Q 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).

Section 1012 of the Code provides that the basis of property is the cost.

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), applicable to the advance refunding bonds, 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)(5) of the proposed regulations published in the Federal Register of December 3, 1975 (40 F.R. 56448), applicable to the advance refunding bonds, provides, in the case of a refunding issue, that prior to the date on which the last obligation of the prior issue is discharged, 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 question in cases concerning the purchase of property at above fair market value is whether the price paid in excess of the market value is for a purpose other than the acquisition of the property. In such cases it is incumbent upon the taxpayer to show that the amount paid is for no purpose other than the acquisition of the property. See Majestic Securities Corp. v. Commissioner, 42 B.T.A. 698 (1940), aff'd, 120 F.2d 12 (8th Cir. 1941) and New Hampshire Fire Insurance Co. v. Commissioner, 2 T.C. 708 (1943).

In this case, Q knowingly paid in excess of fair market value for part of the Treasury bonds. Therefore, Q must show that such excess was paid only for the acquisition of the Treasury bonds.

If Q paid fair market value for the Treasury bonds, the yield on the Treasury bonds would have exceeded the yield on the issue of Q's obligations by more than the amount permitted by section 1.103-13(b)(5) of the proposed regulations. Thus, the amounts that Q paid to S in excess of the fair market value of the Treasury bonds were amounts paid in an attempt to reduce yield on the acquired obligations and are not part of the purchase price of the obligations.

Therefore, in this case, the cost to Q of the Treasury bonds under section 1012 of the Code is their fair market value and not the stated cost of par value. The fact that the purchase price of the Treasury bonds to Q is the fair market value means that the yield on the Treasury bonds exceeds 8 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

Q 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 Q will not prevent the advance refunding bonds from being arbitrage bonds. Thus, the advance refunding bonds issued by Q 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).

¹ Also released as News Release IR-80-32, dated March 19, 1980.