Rev. Rul. 84-37

1984-1 C.B. 25, 1984-11 I.R.B. 4.

                       Internal Revenue Service
                                 Revenue Ruling

        ARBITRAGE BONDS;  REFUNDING ISSUE;  ARBITRAGE YIELD RESTRICTIONS

                           Published: March 12, 1984

Section 61--Gross Income Defined, 26 CFR 1.61-7:  Interest.

Section 103. - -Interest on Certain Governmental Obligations, 26 CFR 1.103-13:  Arbitrage bonds.

(Also Section 61;  1.61-7.)

  Arbitrage bonds;  refunding issue;  arbitrage yield restrictions.  The escrow account in which the proceeds of refunding bonds are held may be invested in materially higher-yielding obligations for the benefit of the city between the discharge date and the date the refunded bonds are actually presented for payment without causing the refunding bonds to be arbitrage bonds under section 103(c) of the Code.

ISSUE

  Will refunding bonds issued by a city be "arbitrage bonds" under section 103(c)(2) of the Internal Revenue Code under the circumstances described below?

FACTS

  On September 1, 1971, CI, a city, issued 30-year construction bonds to make improvements to its water system.  All of the proceeds of the construction bonds were so used by 1973.  The indenture for the bonds provides that CI may redeem them on any semi-annual interest payment date on or after September 1, 1981.  The bonds were issued in bearer form.

  On September 3, 1979, CI issued refunding bonds yielding 10 percent to redeem the construction bonds.  CI deposited all of the proceeds of the refunding bonds in an escrow account with BK, a bank that is the trustee and paying agent for the construction bonds and the refunding bonds.  BK invested all of the proceeds of the refunding bonds in United States Treasury Obligations--State and Local Government Series (SLGS) at a restricted yield of 10 percent. On September 1, 1981, the construction bonds were called for redemption and interest ceased to accrue thereon.  Also, on September 1, 1981, the SLGS were redeemed.

  After the SLGS were redeemed, BK, under the terms of an agreement it had made with CI when the refunding bonds were issued, began investing the escrow account in taxable obligations with a yield materially higher than the yield on the construction bonds and the refunding bonds.  Under the agreement, BK remits to CI a large portion of the amounts earned on the investment of the escrow account.  The investments made by BK do not interfere with the requirement in the indenture for the construction bonds that upon discharge of those bonds the amount held in the escrow account be available on demand to the bondholders.

  A significant number of the holders of the construction bonds did not present their bonds on September 1, 1981 for payment but delayed presentment for several months after the discharge of the bonds.  Therefore, a substantial amount of income was earned on the investment of the escrow account.  CI used the amount it received from the investment of the escrow account for general city purposes.

  CI complied with all requirements of local law and the construction bonds' indenture when notifying the bondholders that the bonds were being redeemed on September 1, 1981.  Neither the construction bonds nor the refunding bonds are industrial development bonds within the meaning of section 103(b)(2) of the Code.

LAW AND ANALYSIS

  Under section 103(a) of the Code, gross income does not include interest on the obligations of a state or a political subdivision of a state.

  Generally, under section 103(c)(1) of the Code any arbitrage bond is treated as an obligation not described in section 103(a).

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

  Generally, under section 1.103-13(b)(5)(iii)(B) of the Income Tax Regulations, the yield on acquired obligations allocated to transferred proceeds is materially higher than the yield on a refunding issue if the yield on such acquired obligations exceeds the

yield on the refunding issue by more than one-eighth of one percentage point.  The same yield restrictions apply to other proceeds of the refunding issue beginning on or after the date on which the last obligation of the prior issue is discharged.

  Under section 1.103-13(b)(11) of the regulations an issue is discharged when  (a) cash is available at the place of payment on the date that the issue is due (whether at maturity or upon prior call for redemption) and (b) interest ceases to accrue on the issue.

  CI discharged the construction bonds on September 1, 1981, because on that date (1) cash was made available to pay the holders at the place of payment and (2) interest ceased to accrue on the bonds.  Under section 1.103- 13(b)(5)(iii)(B) of the regulations, the only proceeds of CI's refunding bonds that would be subject to arbitrage yield restrictions after that date would be transferred proceeds of the construction bonds and other proceeds of the refunding issue.  Sections 1.103-14(e)(3)(vii), (viii) and (ix) of the regulations indicate that other proceeds of a refunding issue are proceeds not used to discharge the prior issue.  For example, proceeds used to pay accrued interest on or issuance costs of the refunding issue would be other proceeds.

  In this case, all the proceeds of the construction issue were spent on construction by 1973, and so there were no transferred proceeds.  In addition there were no other proceeds of CI's refunding bonds.  Therefore, none of the amounts held in the escrow account after August 31, 1981, is subject to arbitrage yield restrictions.

HOLDING

  The refunding bonds issued by CI are not arbitrage bonds under section 103(c)(2) of the Code, and interest on the refunding bonds is excludable from the gross income of the bondholders under section 103(a).

Rev. Rul. 84-37, 1984-1 C.B. 25, 1984-11 I.R.B. 4.