Advance refunding bonds avoid abusive-arbitrage treatment

Plain-English summary

A public issuer used tax-exempt advance refunding bonds and retained current debt-service revenues and a reserve portion in its debt service fund. The IRS found no abusive arbitrage device because the current portion earned less than the yield on the refunding bonds and the transaction did not resemble the prohibited window-refunding example. It also concluded that both retained portions were replacement proceeds held in sinking funds, so they were not excess gross proceeds under the advance-refunding anti-abuse rule. On the submitted facts, the issuer had not used a device to obtain an arbitrage-based material financial advantage apart from lower interest costs.

Ruling snapshot

• Question: Did the advance refunding use an abusive arbitrage device, create excess gross proceeds, or obtain a prohibited arbitrage advantage?
• Outcome: Advice given
• Key authorities: IRC §§ 103, 148, 149(d)(4); Treas. Reg. §§ 1.148-1(c), 1.148-10, 1.149(d)-1

Full text (IRS public release)

                        INTERNAL REVENUE SERVICE
              NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                          September 30, 2014

Number: 201538013
Release Date: 9/18/2015
Third Party Communication: None
Date of Communication: Not Applicable

Index (UIL) No.: 148.00-00
CASE-MIS No.: TAM-114520-14

Director

     Taxpayer’s Name:                            ------------------------------------------------------
     Taxpayer’s Address:                         -------------------------------
                                                 ------------------------------
     Taxpayer’s Identification No                ----------------
     Year(s) Involved:                           -----
     Date of Conference:                         ---------------------------

LEGEND:

Refunding Bonds = ----------------------------------------------------------------------------
----------------------------------------------------------------------------
--------------------

Issue Date = ------------------

Issuer = ------------------------------------------------------

a = -----------------

b = -------------- ---

c = --------------

Date 1 = ---------------------

Period 1 = -------------------------------------------------------

TAM-114520-14 2

d = ---------

e = ------

ISSUE(S):

1. Was an abusive arbitrage device, as defined in § 1.148-10(a)(2) of the Income Tax
   Regulations, used in connection with the Refunding Bonds?

2. Does either the Reserve Portion or the Current Portion of the Refunding Bonds
   constitute excess gross proceeds under § 1.148-10(c)(2)?

3. Are the Refunding Bonds an advance refunding in which a device was employed to
   obtain a material financial advantage (based on arbitrage) apart from savings
   attributable to lower interest rates, as described in § 149(d)(4) of the Internal Revenue
   Code (the Code)?

CONCLUSION(S):

1. No abusive arbitrage device, as defined in § 1.148-10(a)(2), was used in connection
   with the Refunding Bonds.

2. Neither the Reserve Portion nor the Current Portion of the Refunding Bonds
   constitutes excess gross proceeds under § 1.148-10(c)(2).

3. The Refunding Bonds are not an advance refunding in which a device was
   employed to obtain a material financial advantage (based on arbitrage) apart from
   savings attributable to lower interest rates, as described in § 149(d)(4).

FACTS:

On the Issue Date, the Issuer issued the Refunding Bonds to advance refund a portion
of the Issuer’s outstanding indebtedness (the Refunded Bonds). By statute, the Issuer
can only pay debt service on the Refunding Bonds from the revenues generated by an
ad valorem tax levied on all taxable property located within the Issuer (the Tax).

On the Issue Date, the Issuer had a debt service fund (the DSF) for the purpose of
payment of debt service on all outstanding tax-exempt debt of the Issuer, including the
Refunded Bonds. Of the total balance in the DSF on the Issue Date, $a was properly
allocated to the Refunded Bonds. Of the portion of the DSF allocated to the Refunded
Bonds, $b (the Current Portion) were revenues from the Tax that the Issuer would have
used to pay the current debt service on the Refunded Bonds were they not being
refunded by the Refunding Bonds. The remaining portion of the DSF allocable to the
Refunded Bonds on the Issue Date was $c (the Reserve Portion), which the Issuer
treated as a reserve fund for the Refunded Bonds.

TAM-114520-14 3

The Issuer stated in the tax certificate for the Refunding Bonds that it would use the
Current Portion to pay a portion of the debt service due on the Refunding Bonds on
Date 1, the first debt service payment date on the Refunding Bonds, and that it would
hold the Reserve Portion as a reserve for the Refunding Bonds. On Date 1, the Issuer
paid debt service on the Refunding Bonds using funds from the DSF. After the
payment, the portion of the DSF properly allocated to the Refunding Bonds, if reduced
by the Reserve Portion and the maximum amount that would qualify as a bona fide debt
service fund for the Refunding Bonds, would have been approximately equal to the
Current Portion.

For both the Refunding Bonds and the Refunded Bonds, the annual debt service
scheduled during Period 1 was notably lower than in the subsequent years. Two of the
serial maturities of the Refunding Bonds were capital appreciation bonds maturing in the
two years immediately following Period 1. The yield on the Refunding Bonds is d%,
which is lower than the yield on the Refunded Bonds. Pursuant to arrangements for the
advance refunding, the Issuer established a defeasance escrow, the earliest maturing
investment in which had a yield of e%. Between the Issue Date and Date 1, amounts in
the DSF were in invested at yields higher than e% but lower than d%.

LAW AND ANALYSIS:

Section 103(a) of the Code provides that, except as provided in § 103(b), gross income
does not include interest on any State or local bond. Section 103(b) provides in part
that § 103(a) shall not apply to any arbitrage bond (within the meaning of § 148).
Section 148(a) provides that, for purposes of § 103, the term “arbitrage bond” means
any bond issued as part of an issue any portion of the proceeds of which are reasonably
expected (at the time of issuance of the bond) to be used directly or indirectly (1) to
acquire higher yielding investments, or (2) to replace funds which were used directly or
indirectly to acquire higher yielding investments.

Section 1.148-10(a)(1) provides that bonds of an issue are arbitrage bonds under § 148
if an abusive arbitrage device under § 1.148-10(a)(2) is used in connection with the
issue. It further provides that this paragraph (a) is to be applied and interpreted broadly
to carry out the purposes of § 148, as further described in § 1.148–0. It also provides
that, except as otherwise provided in § 1.148-10(c), any action that is expressly
permitted by § 148 or §§ 1.148-1 through 1.148-11 is not an abusive arbitrage device
(e.g., investment in higher yielding investments during a permitted temporary period
under § 148(c)). Section 1.148-10(a)(2) provides that any action is an abusive arbitrage
device if the action has the effect of (i) enabling the issuer to exploit the difference
between tax-exempt and taxable interest rates to obtain a material financial advantage;
and (ii) overburdening the tax-exempt bond market. Section 1.148-10(a)(3) provides
that an action may exploit tax-exempt interest rates under § 1.148-10(a)(2) as a result of
an investment of any portion of the gross proceeds of an issue over any period of time,
notwithstanding that, in the aggregate, the gross proceeds of the issue are not invested
in higher yielding investments over the term of the issue.

TAM-114520-14 4

Section 1.148-10(d), example 3(i) provides the following example of a window
refunding. Authority issues its 1994 refunding issue to refund a portion of the principal
and interest on its outstanding 1985 issue. The 1994 refunding issue is structured using
zero-coupon bonds that pay no interest or principal for the 5-year period following the
issue date. The proceeds of the 1994 refunding issue are deposited in a refunding
escrow to be used to pay only the interest requirements of the refunded portion of the
1985 issue. Authority enters into a guaranteed investment contract with a financial
institution, G, under which G agrees to provide a guaranteed yield on revenues invested
by Authority during the 5-year period following the issue date. The guaranteed
investment contract has a yield that is no higher than the yield on the refunding issue.
The revenues to be invested under this guaranteed investment contract consist of the
amounts that Authority otherwise would have used to pay principal and interest on the
1994 refunding issue. The guaranteed investment contract is structured to generate
receipts at times and in amounts sufficient to pay the principal and redemption
requirements of the refunded portion of the 1985 issue. A principal purpose of these
transactions is to avoid transferred proceeds. Authority will continue to invest the
unspent proceeds of the 1985 issue that are on deposit in a refunding escrow for its
1982 issue at a yield equal to the yield on the 1985 issue and will not otherwise treat
those unspent proceeds as transferred proceeds of the 1994 refunding issue. The 1994
refunding issue is an issue of arbitrage bonds since those bonds involve a transaction
or series of transactions that overburdens the market by leaving bonds outstanding
longer than is necessary to obtain a material financial advantage based on arbitrage.
Specifically, Authority has structured the 1994 refunding issue to make available for the
refunding of the 1985 issue replacement proceeds rather than proceeds so that the
unspent proceeds of the 1985 issue will not become transferred proceeds of the 1994
refunding issue.

Section 1.148-10(d), example 3(ii)(B) provides that, in the following circumstances, the
result would be the same as in example 3(i). The facts are the same as in example 3(i)
except that there are no unspent proceeds of the 1985 issue and Authority invests the
released revenues at a yield materially higher than the yield on the 1994 issue.

Section 1.148-10(c)(1) provides that, except as otherwise provided in § 1.148-10(c), an
abusive arbitrage device is used and bonds of an advance refunding issue are arbitrage
bonds if the issue has excess gross proceeds. Section 1.148-10(c)(2) provides that
excess gross proceeds means all gross proceeds of an advance refunding issue that
exceed an amount equal to 1 percent of sale proceeds of the issue, other than gross
proceeds allocable to, among other things, a reasonably required reserve or
replacement fund for the refunding issue or investment proceeds of such a fund and
replacement proceeds in a sinking fund for the refunding issue.

Section 1.148-1(c)(1) provides that amounts are replacement proceeds of an issue if the
amounts have a sufficiently direct nexus to the issue or to the governmental purpose of
the issue to conclude that the amounts would have been used for that governmental
purpose if the proceeds of the issue were not used or to be used for that governmental

TAM-114520-14 5

purpose. For this purpose, governmental purposes include the expected use of
amounts for the payment of debt service on a particular date. The mere availability or
preliminary earmarking of amounts for a governmental purpose, however, does not in
itself establish a sufficient nexus to cause those amounts to be replacement proceeds.
Replacement proceeds include, but are not limited to, sinking funds, pledged funds, and
other replacement proceeds described in § 1.148-1(c)(4), to the extent that those funds
or amounts are held by or derived from a substantial beneficiary of the issue. A
substantial beneficiary of an issue includes the issuer and any related party to the
issuer, and, if the issuer is not a state, the state in which the issuer is located. A person
is not a substantial beneficiary of an issue solely because it is a guarantor under a
qualified guarantee. Section 1.148-1(c)(2) provides that sinking fund includes a debt
service fund, redemption fund, reserve fund, replacement fund, or any similar fund, to
the extent reasonably expected to be used directly or indirectly to pay principal or
interest on the issue.

Section 149(d)(1) provides that nothing in § 103(a) or in any other provision of law shall
be construed to provide an exemption from Federal income tax for interest on any bond
issued as part of an issue described in paragraph (2), (3), or (4). Section 149(d)(4)
provides that an issue is described in this paragraph if any bond (issued as part of such
issue) is issued to advance refund another bond and a device is employed in
connection with the issuance of such issue to obtain a material financial advantage
(based on arbitrage) apart from savings attributable to lower interest rates. Section
1.149(d)-1(b) provides that an advance refunding issue employs an abusive device and
is described in § 149(d)(4) if the issue violates any of the anti-abuse rules under
§ 1.148-10. The report of the Senate Committee on Finance regarding H.R. 3838, the
Tax Reform Act of 1986, (the Senate Report) provides the following example of one of
the types of transactions that are to be treated as devices for purposes of § 149(d)(4):

 Pursuant to a transaction or series of transactions in connection with the
 issuance of advance refunding bonds, proceeds of the refunding bonds
 are allocated to amounts used to pay debt service on the refunded bonds
 which, absent the refunding, would have been paid with proceeds (other
 than proceeds in a reasonably required reserve fund) of the prior issue.
 Assume, for example, that proceeds of the refunding bonds are allocated
 to amounts used to pay the next installment of debt service on the
 refunded bonds. Absent the refunding, the next installment of debt service
 would have been paid with revenues accumulated on or before the date of
 issue of the refunding bonds (or capitalized interest on the refunded
 bonds). The method of allocation adopted by the issuer permits the issuer
 to allocate the revenues to amounts used to pay a later installment of debt
 service on the refunded bonds and to invest the revenues and the
 earnings thereon substantially longer than they would have been invested
 absent the refunding. The allocation method is a device in that it enables
 the issuer to obtain a material financial advantage that would not have

TAM-114520-14 6

 been available if proceeds of the refunding bonds had not been allocated
 to amounts used to pay debt service which otherwise would have been
 paid with the prior issue proceeds.

S. Rep. No. 99-313, at 850 (1986).

Issue 1

For the Refunding Bonds to be arbitrage bonds under § 1.148-10(a), some action must
have had the effect of enabling the Issuer to exploit the difference between tax-exempt
and taxable interest rates to obtain a material financial advantage. We see no evidence
of such exploitation. Between the Issue Date and Date 1 (the only time period for which
facts were provided), the Issuer invested the Current Portion (the only amount
discussed by the Service in connection with this issue) in the DSF and earned a yield on
those investments that was lower than d%, the yield on the Refunding Bonds. The
Issuer’s investment of the Current Portion at a yield higher than e%, the yield on the
earliest maturing investments in the defeasance escrow, did not enable it to exploit the
difference between tax-exempt and taxable interest rates to obtain a material financial
advantage.

Although the Refunding Bonds are comprised in small part of capital appreciation
bonds, they do not resemble the impermissible window refunding described in § 1.148-
10(d), ex. 3(ii)(B). The Issuer paid both principal and interest on the Refunding Bonds
in each year during Period 1, the purported window. In addition, the debt service
schedule on the Refunding Bonds appears to have been structured to match that on the
Refunded Bonds. Although we have no information regarding the yield at which the
issuer invested any other revenues from the Tax, it invested the Current Portion at a
yield below that on the Refunding Bonds. While we do not conclude that refundings
with different facts will never be window refundings of the sort described in § 1.148-
10(d), ex. 3(ii)(B), we cannot conclude on the facts presented here that the Refunding
Bonds are such a refunding.

On the facts presented, we see no other reason to conclude that the Issuer took some
action to exploit the difference between tax-exempt and taxable interest rates to obtain
a material financial advantage. We therefore conclude that no abusive arbitrage device,
as defined in § 1.148-10(a), was used in connection with the Refunding Bonds. (We
express no opinion regarding, and cannot determine based on the facts submitted,
whether the Issuer’s actions had the effect of overburdening the tax-exempt bond
market.)

Issue 2

The Reserve Portion and the Current Portion are not excess gross proceeds under
§ 1.148-10(c) because both are replacement proceeds in sinking funds for the refunding
issue. As defined in § 1.148-1(c), replacement proceeds include sinking funds, and

TAM-114520-14 7

sinking funds include a debt service fund, a reserve fund, or any similar fund, to the
extent reasonably expected to be used directly or indirectly to pay principal or interest
on the issue. Both the Current Portion and the Reserve Portion are held in sinking
funds for the Refunding Bonds; the Current Portion is held in a debt service fund, the
Reserve Portion is held in a reserve fund, and both amounts are reasonably expected to
be used to pay principal or interest on the Refunding Bonds. Because the Current
Portion and the Reserve Portion are held in sinking funds, they are replacement
proceeds. (We express no opinion on whether the Reserve Portion is held in a
reasonably required reserve or replacement fund.)

Issue 3

We see no device employed to obtain a material financial advantage (based on
arbitrage) apart from savings attributable to lower interest rates, as described in
§ 149(d)(4). In the example in the Senate Report, proceeds of the refunding issue are
allocated to amounts used to pay debt service on the refunded issue which, absent the
refunding, would have been paid with replacement proceeds of the refunded issue.
Likewise, in the refunding at issue here, the Issuer used proceeds of the Refunding
Bonds held in the defeasance escrow to pay debt service on the Refunded Bonds
which, absent the refunding, might have been paid with the Current Portion, an amount
that was replacement proceeds of the Refunded Bonds. In the example in the Senate
Report, however, the issuer’s allocations permit it to invest the replacement proceeds of
the refunded issue, which are eligible to be invested at the yield of the refunded issue, a
yield presumably higher than that of the refunding issue, for a longer period than would
have been possible if it had allocated those amounts to the earliest possible payment of
debt service on the refunded issue. In the case at hand, however, the Current Portion
was, according to the facts presented, invested at a yield lower than that on the
Refunding Bonds. Thus, the Issuer has not obtained a material financial advantage of
the kind described in the example in the Senate Report.

As stated in our analyses of Issues 1 and 2 above, we conclude that the facts
demonstrate neither an abusive arbitrage device of the kind contemplated in § 1.148-
10(a) nor excess gross proceeds under § 1.148-10(c). We find no evidence in the facts
submitted of any other device employed in connection with the issuance of the
Refunding Bonds to obtain a material financial advantage (based on arbitrage) apart
from savings attributable to lower interest rates, as described in § 149(d)(4).

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.