Rev. Rul. 80-91

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 P is a political subdivision of the state of O that was created by O to construct, finance and operate college dormitories in O. On January 2, 1974, P issued bonds that were used to construct dormitories.

On January 7, 1976, P issued advance refunding bonds to refund the 1974 bonds. Proceeds of the refunding bonds were to be held in escrow until 1984. The yield on the refunding bonds was 7 percent, as computed under section 1.103-13(c) of the proposed Income Tax Regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944). A major portion of the proceeds of the refunding bonds were invested in United States Treasury obligations--State and Local Government Series (SLGS), at a restricted yield that was not materially higher than the yield on the advance refunding bonds. Amounts representing a minor portion of the proceeds of the advance refunding bonds were invested at an unrestricted yield of 9 percent. At the time of issuance P executed a certification in accordance with the provisions of section 1.103-13(a)(2)(ii) of the proposed regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944).

On January 2, 1980, P redeemed a portion of the SLGS constituting the major portion of the escrow investment and redeemed all of the SLGS constituting the minor portion of the escrow investment and reinvested them in a new series of SLGS. P allocated 52 percent of the reinvested SLGS to the major portion and 48 percent to the minor portion. The reason P entered into this escrow restructuring transaction was to invest the minor portion at a rate higher than 9 percent. P paid $225,000 in "costs" to financial advisors and counsel in connection with the escrow restructuring. A reasonable fee for such services was $100,000.

Although P entered into the transaction for the purpose of increasing the yield on its minor portion investments, P allocated 47 percent of the "costs" of the transaction to the major portion investments, which are subject to restrictions on yield, and 53 percent to the minor portion investments, which are not subject to restrictions on yield. Thus, P took into account 47 percent of its "costs" for the escrow restructuring transaction ($105,750) in computing the yield on the major portion of the SLGS subject to yield restrictions.

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), 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(c)(1) of the proposed regulations published in the Federal Register of May 3, 1973 (38 F.R. 10944), provides that an amount equal to the sum of the administrative costs of issuing, carrying, and repaying an issue of governmental obligations shall be treated as a discount on the selling price of such issue. An amount equal to the sum of the administrative costs to be incurred in purchasing, carrying, and selling or redeeming a class of acquired obligations shall be treated as a premium on the purchase price of such acquired obligations.

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.

P allocated 47 percent of the "costs" of the escrow restructuring to the 52 percent of the SLGS that were reinvested as a major portion. In addition, P allocated 53 percent of the "costs" of the escrow restructuring to the 48 percent of the SLGS that were reinvested as a minor portion. Because the underlying motive and real purpose of the escrow restructuring was to increase the yield on the securities in the minor portion, the allocation of 47 percent of the administrative costs to the major portion is unreasonable. As a result, the excessive amounts may not be taken into account in computing the yield on the major portion investments. Thus, the yield on the SLGS allocated to the major portion exceeds 7 percent.

The result would be the same even if it were reasonable to allocate 47 percent of the administrative costs of the escrow restructuring to the major portion because the "costs" paid by P in excess of reasonable administrative costs may not be taken into account in computing the yield on the major portion investments.

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

P 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 P will not prevent the advance refunding bonds from being arbitrage bonds. Therefore, the advance refunding bonds issued by P 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.