1. Introduction

Welcome to the

realize that this is a complex area of the law that we are asking you to start to master. The

authors of the following subchapters would like to make you a promise. By reading and

have a little fun in the process.

buying dollars in France for immediate resale in Italy where the market price for dollars is

higher. But arbitrage has a specialized meaning for tax-exempt bonds as explained below.

2. What is Arbitrage?

Tax-exempt bonds generally have lower interest rates than taxable bonds. This is

taxed on the interest that they receive. For example, a city that is able to issue a

an investment profit of 2 percent because the city itself is, of course, not a taxable entity.

The arbitrage rules try to keep state and local governments from issuing more bonds than

otherwise necessary to take advantage of the investment opportunities, or "arbitrage,"

explained on the next page.)

3. Purposes of the Arbitrage Rules

The purposes of the arbitrage rules are stated in Reg.1.148-0(a):

state and local governments by taking away the investment benefits of arbitrage. If you

think about the rules that follow in light of the motivations to earn arbitrage, they will be

easier to understand.

4. Another Way of Thinking About Arbitrage

One way of thinking about the tax-exemption for interest on state and local bonds

governmental purposes. Thus, the arbitrage rules deal with the amount of subsidy given to

a state or local government. This is different from the "use" rules (for example, under IRC

141 and 145), which concern who gets the subsidy rather than the amount of the subsidy.

One goal of the arbitrage rules is to assure that the federal subsidy is fairly applied in

proportion to real governmental purposes of state and local governments.

5. Preview of the Chapters

understanding these provisions. In addition, it will give you a better sense of the prior law

that you may need to apply if you are examining bonds issued many years ago.

Subchapter 2 deals with yield, which is probably the most important concept to

understand in applying the arbitrage rules. The chapter starts by discussing some basic

arbitrage. Not only is an understanding of yield necessary for arbitrage and rebate, you

may find it useful for your personal finances. You will now be able to make that informed

decision between the 15 year fixed mortgage and the 20 year adjustable.

Subchapters 3 and 4 discuss the two basic arbitrage rules: yield restriction under

an arbitrage profit, but in different ways.

exceptions that allow unrestricted investment in certain types of special funds.

Subchapter 4 discusses the rebate rules of section 148(f). These rules in general

provide that, even if an issuer can invest at a higher yield because of the exceptions to

exceptions apply to allow the issuer to retain arbitrage profits.

most part directed at an arbitrage problem. These rules determine when bond proceeds are

the funds allocated no longer need to be yield-restricted.

tax-exempt bond issue is like the refinancing of your home mortgage. The issuer borrows

new debt to pay off old debt. Refundings and advance refundings involve some of the

outstanding are refunding bonds. In addition, advance refundings may be the type of bond

that is most susceptible to arbitrage abuse. This won't be the last time we discuss these

work.

Replacement rules in substance are a statutory "substance over form" rule to prevent

arbitrage motivated borrowing. These concepts are particularly important in analyzing

possible abuses.

Subchapter 8 winds up the arbitrage discussion by offering some practical

examination suggestions.

rules.

(1) Generally, applicants do not

(4) Pattern language currently in MS76G-33 for determination letters

arbitrage bonds on any sizeable scale would "drastically" increase the cost of state and

local government borrowing to finance legitimate governmental functions. The language

of the Tax Reform Act of 1969.

viewed arbitrage bonds as a distortion of the basic purpose of the interest exemption

interest exemption is viewed as a federal subsidy, then permitting interest exemption for

arbitrage bonds represents a waste of federal funds. Further, the Treasury believed that

issued as a part of an issue all or a major portion of the proceeds of which are reasonably

expected to be used directly or indirectly--

the date the bonds are issued. This means that generally events after the issue date would

not make a bond taxable. For example, an issuer certifies on the day of issuance that it

reasonably expects not to earn arbitrage - the no arbitrage certificate - which you will find

in the bond transcript. In most cases the bonds would not have been considered arbitrage

bonds even if arbitrage profits were earned. You can see why the statutory system needed

some work. The second important rule is yield restriction of investments. This means that,

in order for a bond to be tax-exempt, the amount borrowed could not be invested to make

a profit (that is, the investment return couldn't be higher than the borrowing cost).

In addition, the former IRC 103(c) provided for exceptions to permit investment of

bond proceeds at unrestricted yield under certain specific conditions.

4. The Arbitrage Regulations

6. Rebate Regulations

rebate requirement under IRC 148(f). For the most part, the 1979 arbitrage regulations

continued to be effective and provided the rules for yield restriction. In some respects,

however, the May 1989 regulations superseded the 1979 regulations.

guidance on fundamental issues, and overly detailed in their treatment of some obscure

abusive transactions. One problem is that no real attempt was made to mesh the 1979

arbitrage regulations with the new rebate rules. This makes the two sets of regulations

somewhat difficult to read together. For example, the May 1989 regulations use certain

In January 1992 proposed regulations were issued on rebate accounting rules,

rebate spending exceptions and refunding rules. The accounting rules and the spending

May 1989 regulations. In May 1992 the proposed regulations were finalized, along with

the rest of the May 1989 temporary regulations, with some changes.

In November 1992 new proposed regulations were issued under section 148. These

regulations were a complete rewrite and reorganization of the 1979 arbitrage regulations

and the May 1992 rebate regulations. These new arbitrage and rebate regulations were

mom at a discount which is a fairly expensive way to go,

of two years and to pay interest on the $100 at 8 percent. Your actual borrowing cost

premium.

somewhat less frequently, issued at a premium.

Because yield can be dramatically affected by sale of bonds at a discount or

premium, the regulations provide special rules for these situations. One important point to

twerp" interest on the second hundred dollars at 10% as well as the first hundred at 8%.

depending on current market conditions.

simplification because yield generally needs to be computed only once. The regulations

identify certain cases where subsequent events can significantly distort yield, such as

early redemption of bonds that are issued at a significant discount or premium. The

regulations provide for some special rules to deal with these cases.

The basic rule for variable yield issues is much different. For these bonds, yield

example, a 20- year issue commonly would have bonds with 12 different interest rates.

Each maturity for the first 10 years might have a different interest rate. (Short-term bonds

with different interest rates in each succeeding year are called "serial bonds"). In addition,

the bonds maturing in years 15 and 20 might have different interest rates. (These

semiannually, a typical yield computation may involve 40 to 60 different entries.

8. Issue Price

example above, issue price is $200. Issue price can be tricky.

Now your kid brother tells you that he does not want to make a loan to you.

Instead, he tells you that he knows a secret investor who would like to make the loan to

you. (You don't ask.) He tells you that he's going to make the $200 loan to you and then

sell your $200 note to the secret investor for $200. Of course he is going to charge you $2

as a fee for acting as a middleman. You actually receive $198 for your $200 loan. What is

your issue price -- $198 or $200? The answer under the 1986 Act is $200. You do not get

to reduce your issue price by the amount of costs that you pay to receive the loan. You are

$2 fees would be called "costs of issuance."

purposes it is treated as receiving $10,000,000 and paying $200,000 to the underwriter.

The issue price is $10,000,000.

the Marsh City bonds would have been $9,800,000. This result stems from a 1982 court

9. Qualified Guarantees

Suppose that you propose to borrow $100 from your kid brother and to pay him

your finances are weak, you may not be able to pay him back the money. After all, he

knows mom absconded with all your savings. He tells you that he's willing to loan you the

If you get this guarantee, he'll loan you the money at 6 percent. He's willing to take the

lower interest rate with the guaranteed loan because he won't need to worry about the risk

7.5 percent (6 percent interest plus 1.5 percent in guarantee fees). The regulations provide

reasonably expect that the present value of the fees for the guarantee will be less than the

our simple example, the bank guarantee would meet this rule because the present value of

the fee of 1.5 percent per year is less than the present value of the interest rate savings of

2 percent per year. Another important requirement is that the guarantee must be a

transferred to the guarantor.

Certainly, you are not going to just keep the proceeds in your office safe. You want to

place the bond proceeds in an investment account so that they will make money while the

project is put into place.

Your financial advisor tells you that you can invest in taxable securities that have a

money from the 2 percent difference. There is only one problem with your financial

Suppose you took the advice of your financial advisor, investing the bond proceeds

in taxable securities yielding 12 percent. After you have made this investment, your

attorney advises you that the bonds are arbitrage bonds. What are the consequences?

Because the bonds are now arbitrage bonds, the interest is no longer tax-exempt to

the bondholders. Your bond trustee will be required to file Form 1099 for the interest

received by each bondholder. Once they receive the 1099-INT forms from the trustee, the

bondholders will have to report the interest to the Service on their returns. Finally, if your

bonds are determined to be arbitrage bonds you, the mayor, may have a more difficult

time selling new bond offerings, because investors may not want to take a chance on your

bonds. It's time to find another financial advisor. Now, let's look at the purpose behind the

arbitrage rules.

2. Purpose

continued to invest your bond proceeds at a 12 percent yield, you might be able to fund a

significant portion of the hospital construction through the 2 percent difference in yield

between the tax-exempt bonds and the taxable investments you purchased. If you were

able to let your bond proceeds earn 12 percent for a long period, you might make enough

on the investment to pay for most of the project. In order to make as much investment

profit as possible, you might issue your bonds earlier than you otherwise would, solely to

have a longer time to invest, or issue more bonds than you otherwise would, solely to

have more proceeds to invest.

3. Section 148(a): A Continuation of Prior Law

any portion of the proceeds of which are reasonably expected (at the time of issuance of

the bond) to be used directly or indirectly to (1) acquire higher yielding investments, or

(2) to replace funds which were used directly or indirectly to acquire higher yielding

investments." Note that this is very similar to the definition in former IRC 103(c). The

rule looks to reasonable expectations on the issue date and in general requires yield

restriction of investments.

intentionally invests in higher yielding investments in a way that is not otherwise

4. Proceeds

Reg. 1.148-1 defines "gross proceeds" as "any proceeds and replacement proceeds

of an issue." "Proceeds" is defined as "any sale proceeds, investment proceeds, and

types of proceeds to understand. Sale proceeds are basically what an issuer gets from a

borrowing on the issue date. In the terminology of the regulations, sale proceeds are "any

amounts actually or constructively received from the sale of the issue, including amounts

used to pay underwriters' discount or compensation and accrued interest other than

pre-issuance accrued interest." Investment proceeds are investment earnings on proceeds.

(Doesn't sound like you, but this is fiction.) Interest rates have dropped, so you borrow

$100 from a bank at a 7 percent yield to pay off your grandmother immediately. As soon

as you pay off the 9 percent borrowing, you are in effect borrowing at 7 percent. Your

$40 of unspent proceeds is now being carried by 7 percent debt rather than 9 percent debt.

discussed in greater detail in subchapter 6.

5. Purpose Investments and Nonpurpose Investments

regulations have different rules for two general types of investments: purpose investments

governmental purposes of an issue. Examples are a loan made to a 501(c)(3) organization

with the proceeds of a qualified 501(c)(3) bond and the mortgage loans made to

homeowners with the proceeds of qualified mortgage bonds. Purpose investments only

activity bond) issues no purpose investments are made because the state or local

government directly spends the bond proceeds.

to Marsh Community Hospital, a 501(c)(3) organization. The loan to Marsh Community

immediately spend all of the $10 million, but rather invests it until needed for

will be nonpurpose investments.

This article focuses mostly on the arbitrage rules that apply to nonpurpose

investments. Among other things, the rebate requirement applies only to nonpurpose

investments and not to purpose investments.

Special rules apply to a particular type of purpose investment called a "program

investment." These rules generally deal with governmental programs that need to make a

large number of loans with the proceeds of tax-exempt bonds. For example, a housing

the bond yield (generally 1 1/2 percent) for program investments on the theory that the

administrative costs of operating the program are greater than the cost of making a single

loan.

rules for purpose investments.

6. Investment Property

501(c)(3) bonds.) This means that issuers can avoid the yield restriction and rebate

requirements altogether by investing in other tax-exempt bonds. For certain types of

bonds is a common practice for issuers. As Mayor of Marsh City you may want to invest

You won't have to yield restrict or rebate, saving yourself a major headache.

7. Reasonable Expectations

certificate. See former Reg. 1.103-13(a). The regulations provided, however, that an

issuer could not in general establish matters of law in a certificate, including whether a

bond was an arbitrage bond. The regulations contained a more liberal provision for issues

with a face amount of $2,500,000 or less. This "arbitrage certificate" or "non-arbitrage

certificate," (the terminology you use is a matter of personal preference) is a part of

almost all tax-exempt bond deals. Typically it appears as a separate document in the bond

bonds comply with the arbitrage rules.

investments specified in the regulations. Most notably, the rule cannot be applied to

advance refundings. Why would an issuer need to do this? An issuer cannot benefit the

That would be passing on the benefit of tax exempt bond financing to a third party. So, in

practice, it may be difficult to yield-restrict.

The yield reduction payment is a new provision in the June 1993 regulations.

out investing too long, the bonds will be arbitrage bonds. We just said that all extra

arbitrage profits have to be rebated. Not quite true. (In tax law, there are no absolute rules

- including this one.) Rebate has its own "spending exceptions" which are the subject of

the next subchapter.

does the Code establish two sets of rules getting at the same purpose? In other words,

why did Congress layer a new set of rules on top of the yield restriction rules? The answer

restriction rules tougher. For instance, Congress could have eliminated all exceptions to

purchase investments at fair market value. The arbitrage rules generally prohibit paying

artificially low yield in order to comply with yield restriction. Although the yield

restriction rules apply to all issues, in practice issuers usually don't have to yield restrict

because of the availability of exceptions. In a typical non-refunding (or "new money")

bond issue, all of the proceeds will qualify for an exception from yield restriction. The

of issue.

paid. If bondholders are taxed, an issuer would likely be sued by the bondholders. Also,

the issuer's name could be damaged in the debt markets, so that the issuer could have

more difficulty selling its bonds in the future.

In conduit bond issues, where the issuer loans the bond proceeds to a conduit

borrower, the bond documents will usually require the conduit borrower to pay rebate.

in the loan agreement to make all required rebate payments. The conduit issuer typically

will have an interest in seeing that the correct amount of rebate is paid.

amount. The Commissioner may waive all or part of the penalty. The penalty for private

percent. Qualified 501(c)(3) bonds can take advantage of the 50% penalty. Interest

accrues at the underpayment rate under IRC 6621.

3. Exceptions to Rebate

There are two major types of exceptions to rebate: (1) spending exceptions and (2)

small issue exceptions. In addition, the Code and the regulations provide certain

additional exceptions to simplify computations.

A. Spending Exceptions

The idea behind the spending exceptions is that, if bond proceeds are spent fast,

there's less opportunity to earn arbitrage profits. In addition, if bond proceeds are spent

discouraging issuers from issuing bonds for investment profit.

One important point to keep in mind about all of the spending exceptions is that

they usually do not apply to all of the proceeds of an issue. For example, the spending

exceptions generally don't apply to amounts held in a reasonably required reserve fund.

be due on investment earnings on the reserve fund.

The 6-month exception and 2-year construction exception are created by statute.

The 18-month exception is created by regulation. Specific rules for all of the spending

exceptions are provided in Reg. 1.148-7.

lesser of 5% or $100,000 can be held over for another six months if the rest is spent in the

first six months.

if gross proceeds of an issue are spent within 18 months according to the following

schedule measured from the issue date:

1) at least 15 percent within 6 months;

special meaning as for the 6-month exception, so that the exception does not apply to

amounts in a reasonably required reserve fund. This means that you only need to spend

85% as sales proceeds minus the 4R Fund. On the other hand, like the 2-year construction

exception, the last spending requirement can be satisfied even though the issuer has not

spent a 5 percent reasonable retainage on the last spending date.

The 18-month exception requires that all gross proceeds of the issue must meet the

projects. This means that the issue must meet the expenditure test, the time test, and the

Subchapter 3.

The 18-month exception was created in response to comments from issuers that the

accommodate many traditional, non-arbitrage motivated bond issues. The 18-month

by the 6-month exception but it's longer so the issuer gets to keep more profit (other than

for refunding) and it is simpler to use than the 2-year construction exception.

cannot elect to apply the 18-month exception retroactively. It only applies to bonds issued

on or after July 1, 1993.

2) at least 45 percent within 12 months;

3) at least 75 percent within 18 months; and

to most types of private activity bonds. The exception also requires that the issuer must

reasonably expect that at least 75 percent of the "available construction proceeds" of the

another special definition that excludes, among other things, sale proceeds in a reasonably

required reserve or replacement fund.

The scope of the exception depends upon the meaning of "construction." The

regulations provide that "construction expenditures" generally refer to the cost of making

improvements to real property, although certain expenditures with respect to personal

property also qualify. More guidance is provided in Reg. 1.148-7(g).

An issuer may elect to apply the exceptions to different portions of an issue as

provided in IRC 148(f)(4)(C)(v). For example, a portion of an issue could qualify for the

2-year construction exception and another portion could qualify for the 6-month

exception.

fails to meet the spending requirement as of any spending date. This provision was

intended to enable issuers to completely avoid the complexities of rebate, but, for a

variety of reasons, appears not to have been widely used.

not exceed the lesser of 3% of the total issue price or $100,000.

B. The Small Issuer Exception

Under IRC 148(f)(4)(D) bonds issued to finance governmental activities of small

completely inapplicable to an issue. If an issue meets this exception, only the yield

money is placed in the 4-R fund, the bond will be an arbitrage bond.

C. Bona Fide Debt Service Fund Exception

IRC 148(f)(4)(A) provides that the investment earnings on bona fide debt service

fund held to match revenues with payment of principal and interest each year. Payments

a debt service fund monthly and out of the fund semiannually. The issuer of Marsh City

Hospital Revenue Bonds may receive payment from the hospital monthly. The issuer

created this exception to rebate. The exception generally applies to all long-term fixed

rate bonds with an average maturity of 5 years or more. You have to consider average

maturity because one bond issuance will have a number of different bonds with different

maturities.

4. Computation of Rebate

1.148-3. The issuer of the bonds must pay to the Federal government an amount equal to

earned if the nonpurpose investments were invested at a rate equal to the yield on the

bonds. The rebate payment must also include any investment earnings on this excess

amount.

For example, assume Marsh City issues bonds for $10 million at an 8 percent yield

and invests all of the proceeds for a year at a 10 percent yield before spending them. The

Several factors, however, make actual computations more complicated. Typically an

at 9 percent yield. A rebate computation must in effect blend together all of these

the "future value" method which is a method of valuing investments of different types

according to the same measure.

compute yield on the issue; (2) determine payments for and receipts of nonpurpose

interest, and whether any payments are made for qualified guarantees.

must be obtained from the issuer. Generally the required information will not all be in the

bond transcript, because the bond transcript is put together to show what happened on the

closing date, and investments are typically made after the closing date.

the issue to determine future value. This is a way to compare amounts paid or received at

different times taking into account the time value of money.

Let's look at an example to get a better feel for what this means. On January 1,

1994, City A issues $49,000,000 of fixed yield bonds and invests all the sale proceeds.

Does it still work or is rebate too complex? Try the formula - 49,000,000 x (1 + .7/2)

You use 10 periods because rebate is paid after 5 years or 10 semiannual periods. You

investments that have not been received by the issuer.

Some issuers use "fund accounting" in which many projects may be paid for out of

a single fund. These issuers would have difficulty tracing specific amounts in the fund to

a particular project. Accordingly, a project description is sufficient if it identifies the fund

or account from which the original expenditure was paid, by either giving the name of the

fund or describing the functional purpose of the fund. An example of such a description

for our theme Park might be "parks and recreation fund--theme park capital improvement

program."

Although the regulations require a description of the project, reasonable deviations

between a project described in a declaration of official intent and the actual project

financed will not invalidate an otherwise valid official intent. However, the actual project

C. Reasonableness of Official Intent

On the date of the declaration, the issuer's expectation that it will reimburse the

original expenditure with bond proceeds must be "reasonable." Official intents are not

reasonable if they are routinely declared as a matter of course, or are declared in amounts

substantially in excess of the amounts expected to be necessary for the project. Thus, you

can't make a blanket declaration at the beginning of each year saying that you plan to

reimburse for all capital expenditures made during that year.

5. Reimbursement Period Requirement

for the project. You paid it and were obviously not suffering for its lack. Therefore, if an

expenditure is not reimbursed within a relatively short period of time after its payment or

bonds were really issued for the purpose of investing the proceeds.

the project is either placed in service or abandoned. In no event, however, can the

contain special rules that extend the permitted reimbursement period for certain issuers

who issue less than $5,000,000 of bonds during the year, and for certain issues financing

long-term construction projects. Reg. 1.150-2(d)(2)(ii) and (iii).

6. Nature of Expenditure Requirement

rules. Reg. 1.150-2(d)(3) provides that the general rule is that the expenditures to be

reimbursed must be either capital expenditures or costs of issuance for a bond. The

Mayors theme park.

Reg. 1.150-2(d)(3) permits reimbursement for certain types of expenditures in

which proceeds are provided to someone else. Thus, an expenditure satisfies the nature of

student loan, a qualified mortgage loan, or a qualified veterans' mortgage loan.

7. Exceptions to General Operating Rules

percent of the aggregate issue price of the issues that finance or are reasonably expected

to finance the project. Preliminary expenditures include architectural, engineering,

construction. For example, you do some soil testing and surveying to evaluate the site for

the World of Mayors. You pay these expenses without ever having declared official intent

to reimburse. You then reimburse the city with proceeds of bonds issued to finance the

theme park. The fact that the expenses do not satisfy the official intent requirement do not

prevent a qualifying reimbursement. Note that the preliminary expenditures must relate to

the project being financed with the bonds, so you can't reimburse your preliminary theme

park expenditures with the proceeds of a road improvement bond.

8. Special Rules on Refundings

expenditure was a payment of principal or interest on an obligation, or was originally paid

next Subchapter.

9. Anti-abuse Rules

A. General Rule

reimbursement allocation to improperly avoid the yield restriction and rebate

financial advantage, and (2) overburdening the tax-exempt bond market. The only "good"

reimbursement is a reimbursement subject to the regulations which follows the

requirement of the regulations. Although Marsh City's Mayoralty prides itself on being

creative and innovative, there is very little room for creativity here.

B. One-year Step Transaction Rule

would have been used to pay for the expenses financed with a bond issue if the bonds had

not been issued. The special anti-abuse rule in the reimbursement regulations provides

that a purported reimbursement allocation is invalid if, within 1 year of the allocation, the

proceeds for which the allocation was made are used in a way that results in replacement

proceeds being created (except in the case of amounts deposited in a bona fide debt

service fund). For example, you issue your bonds and allocate the proceeds to reimburse

pledge them as security for another issue of bonds. As you will learn in Subchapter 7,

when funds are pledged as security for an issue, they become replacement proceeds of

a way that resulted in the creation of replacement proceeds, the reimbursement allocation

is invalid and those amounts are treated as having always been unspent proceeds of the

not over. What happens to Marsh City when it has bonds paying an interest rate of 10%

and the general interest rate for bonds drops to 8%. If Marsh City was borrowing now, its

debt service expenses could be reduced. Just like when you refinance your house, there

are refinancing options available to Marsh City. Subchapter 6 discusses rules on

refundings. Without this knowledge, you will not be able to adequately direct Marsh

City's financial future.

mayor, your sensitivity to interest rate fluctuations is even greater because of the size of

reasons.

interest rates are rising. You may wish to get out from under covenants that you agreed to

in an earlier financing but have now become onerous. For example, in 1980 Marsh City

used to build an electric generating facility. Revenue from the facility was used to pay

debt service on the prior bonds. In order to market the prior bonds, you had to covenant

that you would not issue any additional debt unless revenue available for debt service was

2.0 times the highest annual debt service. That was a long time ago and the credit

worthiness of the Marsh City electric system has increased. Current investors would only

require a ratio of 1.25. Even though interest rates have risen, you need to refinance so that

you can issue new debt for new projects.

revenue from the debt.

2. Definition of Refunding

First, what is a refunding? The answer might seem obvious: a new borrowing to

you enter into a new loan to pay off an old loan with a higher interest rate. Debt financing

by local governments, however, can be much more complicated than that, and it is not

always easy to tell when a bond issue is a refunding. For example, assume that you

that your new borrowing is a "refunding" of your home mortgage? Or assume that you

obligor of the other issue. An obligor for this purpose may mean either the issuer or the

conduit borrower. It is not a good thing to be considered a refunding bond. The temporary

limitation of "obligor to obligor" is a break. If new bonds are issued by one obligor to

issue.

3. Types of Refundings

A. Current Refunding

If you issue refunding bonds that pay off the prior bonds within 90 days, the

plus any premium Marsh City had to pay for calling the bonds early. To analyze their

Does and other investors can buy bonds with call protection. The issuer gives up the right

to call the bonds until a specific date. So, if you issue your bonds with call protection, are

you sunk, stuck with high interest rate bonds or onerous covenants?

B. Advance Refunding

two sets of bonds outstanding. The first set of bonds will remain out until they are called

and replaced by the advance refunding bonds.

The proceeds of an advance refunding bond are typically put into a refunding

escrow that is invested in high grade U.S. Treasury securities and pledged irrevocably to

pay off the prior bonds. Often the proceeds will be invested for many years until the prior

bonds are to be called. Because fixed rate municipal bonds are often issued with call

Over the years, restrictions on advance refunding bonds have increased. Why all

the attention? With advance refundings a large portion of the bond proceeds is commonly

invested for a long time and more than one set of tax-exempt bonds remain outstanding at

the same time. This increases the burden on the tax-exempt market. This is unlike most

"new money" financing, where the bond proceeds are only invested for a short time

bonds are used to invest and grow to pay off the prior bonds, the arbitrage possibilities

have gotten a lot of attention. Before the arbitrage restrictions can be understood, it is

far the most common.

(1) Net (or Standard) Defeasance

of 4%. You need to do something. You issue new advance refunding bonds. The proceeds

held in an escrow account. The principal plus the interest to be earned will pay off the

prior bonds. This refunding escrow account

gross defeasance be used. In the net defeasance just discussed the bond documents for the

the investment earnings of the advance refunding proceeds in the refunding escrow. (As a

practical matter, there is no real risk because the escrow is invested in federal securities.)

In a gross defeasance investment earnings on the refunding escrow are in effect not taken

into account.

million in five years and no interest before then (a "zero coupon bond"). If Marsh City

does a net defeasance, it needs to issue only about $6.75 million of advance refunding

bonds. This is because the $6.75 million will earn an additional $3.25 million if invested

needed for the governmental purpose.

(3) Crossover

there is no defeasance. The prior bonds are redeemed whenever they can be called and the

new interest rate then replaces the old. This method cannot be used to remove onerous

covenants because there is no defeasance of the prior bonds. Crossover refundings are not

frequently issued, but are more common than gross defeasance refundings. Again, special

rules apply.

4. Transferred Proceeds

have dropped, so that Marsh City can issue bonds at a 4 percent yield to current refund

the 1992 bonds. At the time of the refunding, $3 million of proceeds of the 1992 issue

of the 1992 issue "transfers" to the 1994 issue. This means that, if the proceeds are subject

to yield restriction, the $3 million cannot be invested at a yield that is materially higher

the $3 million of proceeds.

This basic transferred proceeds rule is stated in Reg. 1.148-9(b)(1) as follows:

When proceeds of the refunding issue discharge any of the outstanding

status of the bonds.

(1) The bonds can be defeased and redeemed at the first call date. For

be used for governmental bonds and qualified 501(c)(3) bonds. The safe harbors require

that the remedial actions be taken within specific time periods. The revenue procedure

does not fit into the safe harbors.

Note in particular that the revenue procedure revokes Rev. Rul. 77-416, 1977-2

before March 8, 1993. That revenue ruling provided that under particular facts and

not affect the tax-exempt status of the bonds.

Note also that this revenue procedure only deals with changes of use under certain

payments that cause an issue to meet the private payment test under section 141.

In the Tax Reform Act of 1986 Congress directed the Service to modify Rev. Proc.

procedures. The purpose of the procedure is to set forth safe harbors for when the

provision by a nongovernmental person of management or other services under a contract

will not cause the proceeds to be used in a trade or business under IRC 141. Unified rules

are provided for all types of management and other service contracts.

The revenue procedure implements the Congressional directive and attempts to

what methods of compensation will be considered to be based on net profits.

The revenue procedure includes more explicit related party rules. For example, in

the case of a management contract for a facility financed with proceeds of a qualified

organization's board of directors. In addition, the exempt organization cannot have more

than 20% voting power on the manager's board of directors. The overlapping board

members must not include the chief executive officers of the manager or the exempt

organization. In addition, the manager and the exempt organization cannot both be

as defined in IRC 144(a)(3).

contract that gives a nongovernmental provider a proprietary interest in a facility is not

the only situation in which a contract may result in private business use of the facility.