Rev. Rul. 80-13
1980-1 C.B. 27, 1980-2 I.R.B. 10.
Internal Revenue Service
Revenue Ruling
ARBITRAGE BONDS; YIELD RESTRICTIONS; STATE FUNDS AND BOND PROCEEDS
Published: January 14, 1980
26 CFR 1.103-13: Arbitrage bonds.
Arbitrage bonds; yield restrictions; state funds and bond proceeds. A political subdivision of a state proposes to issue certain bonds to finance a feasibility study. The state is expected to appropriate funds yearly, in an amount at least equal to the cost of the study for that year, that will be placed in an escrow fund. Both the bond proceeds and the escrow fund amount will be invested in acquired obligations yielding a materially higher amount than the bonds. Such investment earnings may be used to finance the study. The issue by the subdivision will not comply with the arbitrage yield restrictions of section 103(c) of the Code.
ISSUE
Will an authority that is a political subdivision of a state fail to 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 circumstances described below?
FACTS
Authority A is a political subdivision of the state of M that was created by M to construct, acquire, finance and operate power facilities in M. Under the law of M, A may issue bonds to finance power projects, but such bonds are not permitted to be secured by the full faith and credit of M.
Since A is a newly created political subdivision of M, A has no revenues or assets. The first project that will be undertaken by A is a study that will determine the feasibility of constructing a hydroelectric power plant in M. A plans to finance the feasibility study through the issuance of $50,000,000 of its eight-year term bonds. Since A has no revenues with which it may pay interest on the bond issue, $23,000,000 of bond proceeds will be used to pay the annual interest due on the bonds. The remaining bond proceeds will be used to pay for the costs of the feasibility study.
In addition, the legislature of M will be requested, in each of its annual sessions, to appropriate funds in an amount at least equal to the cost of the feasibility study for that year. A will place the amounts it receives from the annual appropriations made by the legislature of M in an escrow fund. A anticipates that the initial state appropriation will be made concurrently with the issuance of the bonds. The bond indenture states that no funds appropriated by the legislature of M may be used to conduct the feasibility study. The amounts deposited in the escrow fund and that portion of the $50,000,000 of bond proceeds not used to pay for the cost of the feasibility study will be used to repay the bondholders if A defaults on its bond issue, or if as a result of the study, A determines that the hydroelectric power plant should not be built.
Both the original proceeds of the bonds and the amounts deposited in the escrow fund will be invested in acquired obligations, the yield on which will be materially higher, within the meaning of section 1.103-13(b)(5)(iv) of the Income Tax Regulations, than the yield on the bonds. The investment earnings from the bond proceeds and the escrow fund will be deposited in bond accounts and may be used to finance the cost of the feasibility study. However, the bond indenture provides that the original proceeds of the bonds may be used to pay for the feasibility study only so long as the sum of (1) the balance of original and investment bond proceeds and (2) the balance of the escrow fund and earnings thereon total not less than the principal amount of the bonds outstanding.
The bonds will not be industrial development bonds within the meaning of section 103(b)(2) of the Code.
LAW AND ANALYSIS
Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state, a territory, or a possession of the United States, or any political subdivision of the foregoing, or of the District of Columbia.
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 1.103-13(b)(5)(iv) of the regulations defines the term 'materially higher' in those situations in which it is reasonably
expected that the original proceeds of an issue will exceed the amount necessary for the governmental purpose or purposes of the issue by more than 5 percent of such amount. Any portion of the issue issued solely for the purpose of investing such portion at a materially higher yield as less than a major portion is not issued for a governmental purpose. The yield produced by acquired obligations acquired with the proceeds of such issue (including any acquired obligations held during the temporary periods described in section 1.103-14(b), any amounts invested in the reserve or replacement fund as defined in section 1.103-14(d), and any investments of less than a major portion of such proceeds as described in section 1.103-13(b)(1)) is materially higher than the yield produced by an issue of governmental obligations if the yield produced by the acquired obligations is higher than Y + [($5,000 x Y) / P] where 'Y' stands for the yield on the issue and 'P' stands for the amount of the original proceeds of the issue. Nothing in this subdivision implies that a deliberate over-issuance of less than 5 percent will not be treated as an artifice or device in section 1.103-13(j).
Section 1.103-13(j) of the regulations provides that if an artifice or device is employed in connection with the issuance of a governmental obligation, such obligation will be considered an arbitrage bond within the meaning of section 103(c)(2) of the Code. For purposes of this section, the term 'artifice or device' means a transaction or a series of transactions that attempts to circumvent the provisions of section 103(c) of the Code or sections 1.103-13, - 14, or -15 of the regulations-(1) enabling the issue to exploit the difference between tax-exempt and taxable interest rates to gain a material financial advantage and (2) increasing the burden on the marker for tax-exempt obligations.
Section 1.103-13(j) of the regulations further provides that examples of increased burdens on the market for tax-exempt obligations include selling obligations that would not otherwise be sold, selling more obligations than would otherwise be necessary, and issuing obligations sooner or allowing them to remain outstanding longer than would otherwise be necessary.
Rev. Rul. 78-348, 1978-2 C.B. 95, discusses the application of the replacement theory of section 103(c)(2)(B) of the Code. The replacement theory is based on the principle that an issuer that borrows to invest in higher yielding securities and one that borrows against such securities already owned are in virtually the same position. The revenue ruling provides that a requisite nexus or sufficiently direct relationship must exist between the bonds and higher yielding securities in order to apply section 103(c)(2)(B). Such a nexus or relationship does exist where the securities are pledged as collateral for the bonds. Although a pledge of collateral need not be cast in a particular legal form, 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.
Section 1.103-13(b)(1)(i)(B) of the regulations refers to example (1) in section 1.103-14(e)(7)(ii) to illustrate the application of the replacement theory of section 103(c)(2)(B) of the Code. In that example, a city issued $11,000,000 in bonds to refund a prior issue of $10,000,000 for which there was no reserve or replacement fund. However, the city accumulated a reserve fund of $800,000 for the refunding issue that was pledged as collateral for that issue. In addition the city could not withdraw amounts from the reserve fund during the term of the refunding issue except to pay debt service on the issue. Based on these facts, the regulation concludes that the bond proceeds replace the amounts held in the reserve fund and that the amounts held in the reserve fund are subject to the same arbitrage yield restrictions and generally have the same status as proceeds of the refunding issue. See also Rev. Rul. 78-348, for similar examples of the replacement theory under section 103(c)(2)(B).
M has provides A with an Escrow Fund that may be used only to pay the holders of A's bonds if A defaults on the bonds or if A concludes that the power plant should not be built. Therefore, under section 103(c)(2)(B) of the Code, A's bonds will be issued to replace the amounts in the escrow fund. The fact that the escrow fund will not be fully funded at the time the bonds are issued is not distinguishable from Rev. Rul. 78-348 in which the bond proceeds replaced investment securities already owned by the governmental units.
Under section 1.103-13(b)(5)(iv) of the regulations, the issuance of bonds solely to derive an arbitrage profit is not for a governmental purpose. See Rev. Rul. 79-108, 1979-1, C.B. 75, which concludes that a city issued bonds solely to derive an arbitrage profit and thus made an overissuance of bonds when it obtained from a securities dealer a 60-day loan of 300x dollars that was secured by city-owned U.S. Treasury Notes and invested the proceeds of the loan in a local government investing pool that paid interest at a yield higher than the rate of interest the city paid on its obligation to the securities dealer. Similarly, the issuance of bonds solely to replace funds that are used solely to derive an arbitrage profit is not for a governmental purpose.
In this case, the bond indenture restricts use of original proceeds for the feasibility study to the amount by which the balance of original and investment bond proceeds and the balance in the escrow fund and earnings thereon exceeds the principal amount of the bonds outstanding. During each of the years that the bonds are outstanding only that portion of the original bond proceeds that is matched by investment proceeds and funds appropriated by the legislature and deposited in the escrow fund and the earnings thereon may be used to finance the annual cost of the study. Thus, at no time after the bonds are issued will the sum of the amounts held in the bond accounts and escrow fund, be less than $50,000,000, the face amount of the bonds. In addition, the bondholders will look to the escrow fund and the bond funds and not A for payment of principal and interest on the bonds as is evidenced by the fact that A has no revenues or assets with which it may pay the bondholders in the event of default or a decision not to build the power plant. Therefore, although the form of the transaction is that the bond proceeds will be used to fund the feasibility study, the substance of the transaction is that the feasibility study will be funded only by the earnings on the original bond proceeds and amounts appropriated by the legislature of M and the earnings thereon, and none of the original bond proceeds will be spent for the study. Thus the transaction is the equivalent of M issuing the bonds and placing the proceeds in escrow and financing the feasibility study on a year to year basis with the amounts appropriated by the legislature and the earnings on both the appropriations and the original bond proceeds.
If M had actually issued bonds, and placed the bond proceeds in escrow and invested them for the purpose of obtaining arbitrage profits, the issuance would be considered to have no governmental purpose within the meaning of section 1.103-13(b)(5)(iv) of the regulations. See Rev. Rul. 79-108. The fact that the form of the transaction is that A is issuing the bonds does not change the substance of the transaction that the bonds are being issued for no governmental purpose.
Consequently, it is reasonably expected that the issuance by A of $50,000,000 of its bonds to replace the amounts deposited in the escrow fund will exceed the amount necessary for the governmental purpose of such issue by more than 5 percent of such amount within the meaning of section 1.103-13(b)(5)(iv) of the regulations. Further, A is investing the bond proceeds at a materially
higher yield within the meaning of section 1.103-13(b)(5)(iv). Thus, A has failed to comply with the arbitrage yield restrictions of section 103(c)(2)(A) of the Code.
Further, because the expected annual legislative appropriations of M will be sufficient to conduct the feasibility study, the bonds will not be issued for a governmental purpose, and issuance of the bonds is not necessary. Under section 1.103-13(j) of the regulations, the issuance of bonds that are not necessary creates a burden on the market for tax-exempt bonds. Because the bond proceeds will be invested at a materially higher yield, A will be able to exploit the difference between tax-exempt and taxable interest rates to gain a material financial advantage. Therefore, A is employing an artifice or device in connection with the issuance of the bonds.
Because the amounts deposited in the escrow fund will be replaced by the proceeds of A's bonds, the amounts invested in the escrow fund have the same status and are subject to the same yield restrictions as the bond proceeds. In this case, since the bond proceeds are subject to the yield restrictions of section 1.103-13(b)(5)(iv) of the regulations the amounts deposited in the escrow fund are subject to the same yield restrictions. Since amounts in the escrow fund will be invested at a yield materially higher than that of the bonds, A has failed to comply with the arbitrage yield restrictions of section 103(c)(2)(B).
HOLDING
The issue of A's obligations will not comply with the arbitrage yield restrictions of section 103(c)(2) of the Code, and thus the bonds will be arbitrage bonds within the meaning of section 103(c)(2). Accordingly, interest on the issue of A's obligations will not be excludable from gross income under section 103(a)(1). The result would be the same if M had made an appropriation for the entire cost of the feasibility study on the date of issue.
Rev. Rul. 80-13, 1980-1 C.B. 27, 1980-2 I.R.B. 10.