Final Regulation_TD 8801

[Federal Register: December 30, 1998 (Volume 63, Number 250)]
[Rules and Regulations]
[Page 71748-71752]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr30de98-8]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8801]
RIN 1545-AU39

Arbitrage Restrictions on Tax-Exempt Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations on the arbitrage
restrictions applicable to tax-exempt bonds issued by State and local
governments. Changes to applicable law were made by the Tax Reform Act
of 1986. These regulations affect issuers of tax-exempt bonds and
provide guidance for complying with the arbitrage regulations.

DATES: Effective Date: These regulations are effective on March 1,
1999.
Applicability Date: These regulations are applicable to bonds sold
on or after March 1, 1999.
Issuers may apply these regulations to bonds sold on or after
December 30, 1998 and before March 1, 1999.

FOR FURTHER INFORMATION CONTACT: David White, 202-622-3980 (not a toll-
free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations
have been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under
control number 1545-1490. Responses to these collections of information
are required to obtain the benefits of a safe harbor.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The estimated annual burden per record keeper varies from .75 hour
to 2 hours, depending on individual circumstances, with an estimated
average of 1 hour.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
Desk Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

These final regulations contain amendments to the income tax
regulations (26 CFR Part 1) under section 148 of the Internal Revenue
Code of 1986 (Code). Section 148 provides rules addressing the use of
proceeds of tax-exempt State and local bonds to acquire higher-yielding
investments. On June 18, 1993, final regulations (TD 8476) relating to
the arbitrage restrictions and related rules under sections 103, 148,
149, and 150 were published in the Federal Register (58 FR 33510).
Corrections to these regulations were published in the Federal Register
on August 23, 1993 (58 FR 44451), and May 11, 1994 (59 FR 24350).
On June 27, 1996, a notice of proposed rulemaking (FI-28-96)
relating to the arbitrage restrictions was published in the Federal
Register (61 FR 33405). The proposed regulations provide a rebuttable
presumption for establishing fair market value for United States
Treasury obligations that are purchased other than directly from the
United States Treasury. In addition, the proposed regulations provide a
rebuttable presumption that a solicitation that meets certain
requirements is a bona fide solicitation for the guaranteed investment
contract safe harbor of Sec. 1.148-5(d)(6)(iii). A public hearing was
held on Thursday, October 24, 1996, and written comments were received.
After consideration of all the comments, the regulations proposed by
FI-28-96 are, with modifications, adopted by revision to Sec. 1.148-
5(d)(6)(iii). The changes are discussed below.

Explanation of Provisions

A. In General

Due to concerns regarding the fair market purchase price of United
States Treasury obligations purchased other than directly from the
United States Treasury, the proposed regulations provide a rebuttable
presumption for establishing fair market value. The proposed
regulations generally apply the principles underlying the existing safe
harbor in the arbitrage regulations for establishing fair market value
for guaranteed investment contracts.
The proposed regulations also provide a rebuttable presumption that
a solicitation meeting the requirements of the proposed regulations
will be a bona fide solicitation for the guaranteed investment contract
safe harbor of existing Sec. 1.148-5(d)(6)(iii).
Modifications to the proposed regulations have been made to clarify
various technical aspects in response to comments received.

B. Safe Harbor

Commentators noted that a rebuttable presumption in the proposed
regulations for purchases of United States Treasury obligations
provides a lower level of protection to issuers than the safe harbor
applicable to guaranteed investment contracts. Commentators generally
requested that the final regulations provide a safe harbor for the
purchase of United States Treasury obligations.
The final regulations create a safe harbor for all investments
covered by the regulations, provided that the issuer receives at least
three bids as required by the regulations. The premise of the final
regulations is that a bidding procedure satisfying the requirements of
the final regulations will produce a price that equals fair market
value. If the requirements of the final regulations are not in fact
met, no assumption can be made about the relationship of the price paid
to fair market value. However, all reasonable and prudent actions taken
by the issuer under the circumstances may be considered in determining
whether the issuer paid fair market value.

[[Page 71749]]

C. Scope of Final Regulations

Generally, the proposed regulations apply to United States Treasury
obligations purchased other than directly from the United States
Treasury. Commentators requested clarification regarding the scope of
the proposed regulations and requested that the regulations only apply
to investments purchased for yield restricted refunding and yield
restricted sinking fund escrows. In addition, commentators asked that
the proposed regulations be expanded to apply to other types of
investments that may be purchased for an escrow (e.g., REFCORP strips).
The final regulations apply only to guaranteed investment contracts
and yield restricted defeasance escrows. With respect to yield
restricted defeasance escrows, the final regulations expand the scope
of investments covered by the proposed regulations to apply to all
investments purchased for the escrow (e.g., United States Agency
obligations, REFCORP strips and corporate obligations).

D. Guaranteed Investment Contracts

Commentators requested clarification regarding which investments
are covered by the safe harbor for guaranteed investment contracts and
which would be covered by the proposed regulations.
The term guaranteed investment contract generally does not include
investments purchased for a yield restricted defeasance escrow.
However, the term guaranteed investment contract does include escrow
float contracts and similar agreements purchased for a yield restricted
defeasance escrow. In addition, the term guaranteed investment contract
includes debt service fund forward agreements and debt service reserve
fund agreements (e.g., agreements to deliver United States Treasury
obligations over a period of time).

E. No Last Look

The proposed regulations state that all providers must have equal
opportunity to bid and that no provider is permitted to review other
bids before bidding (e.g., a last look). A small number of commentators
noted that the existence of a last look may result in higher yields
from competing providers. The final regulations retain the no last look
requirement because permitting a last look may adversely affect the
bona fides of the bidding process.

F. Reasonably Competitive Providers

The proposed regulations provide that all bidders are required to
be reasonably competitive providers of investments of the type being
purchased. Numerous comments were received regarding the meaning of the
phrase ``reasonably competitive provider,'' and commentators expressed
concern that a bid from a non-competitive provider may prevent the
requirements of the regulations from being satisfied.
The final regulations modify this provision. The final regulations
provide that the issuer must solicit at least three bids from
reasonably competitive providers and that the issuer must receive at
least one bid from a reasonably competitive provider. For purposes of
the final regulations, a reasonably competitive provider is a provider
that has an established industry reputation as a competitive provider
of the type of investments being purchased. For example, in connection
with the solicitation of bids for a guaranteed investment contract, an
entity that has an established industry reputation as a competitive
provider of guaranteed investment contracts is a reasonably competitive
provider.

G. No Material Financial Interest

The proposed regulations, like the existing safe harbor for
guaranteed investment contracts, provide that the issuer must receive
at least three bona fide bids from providers that have no material
financial interest in the issue. For this purpose, the proposed
regulations provide that underwriters and financial advisors for an
issue are considered to have a material financial interest. Numerous
comments were received regarding the scope of entities that are
considered to have a material financial interest under the proposed
regulations.
The final regulations clarify that, for purchases of any investment
covered by the safe harbor, the lead underwriter in a negotiated
underwriting transaction is deemed to have a material financial
interest in the issue until 15 days after the issue date of the issue.
Any entity acting as a financial advisor with respect to the purchase
of the investment at the time that the bid specification form is
submitted to potential providers is also deemed to have a material
financial interest in the issue. In addition, the final regulations
require the provider to represent that its bid is not based on any
other formal or informal agreement that the provider has with the
issuer or any other person. A provider that is a related party to a
provider that has a material financial interest in the issue is also
deemed to have a material financial interest in the issue.

H. Commercially Reasonable Terms

The proposed regulations provide that the terms of the purchase
agreement must be reasonable. The existing safe harbor for guaranteed
investment contracts provides that the terms of the guaranteed
investment contract, including the collateral security requirements,
must be reasonable. A number of commentators requested clarification
regarding what reasonable means in connection with a solicitation of
United States Treasury obligations.
The final regulations provide that the terms of the bid
specification for any investment covered by the safe harbor must be
commercially reasonable. A term is commercially reasonable if there is
a legitimate business purpose for including the term in the bid
specifications other than to lower the yield or increase the cost of
the bid. For example, in connection with the solicitation of
investments for a yield restricted defeasance escrow, a commercially
unreasonable term would be a hold firm period that is longer than the
issuer reasonably requires.

I. Comparison to State and Local Government Series Securities

The proposed regulations provide that the yield on any United
States Treasury obligation purchased by the issuer may not be less than
the yield then available on State and Local Government Series
Securities from the United States Department of the Treasury, Bureau of
Public Debt (SLGs) with the same maturity. Commentators requested that
the SLGs comparison be removed or that issuers be allowed to make the
comparison on a portfolio-by-portfolio basis. Commentators also
requested guidance about the time period in which the SLGs comparison
is to be made.
In general, the final regulations provide that the safe harbor does
not apply to investments purchased for a yield restricted defeasance
escrow if the lowest cost bid is greater than the cost of the most
efficient SLG portfolio. The final regulations provide that the lowest
cost bid is the lowest bid for the portfolio or, if the issuer compares
bids on an investment-by-investment basis, the aggregate cost of a
portfolio comprised of the lowest cost bid for each investment. Any
payment received by the issuer from a provider at the time a guaranteed
investment contract is purchased (e.g., an escrow float contract) for a
yield restricted defeasance escrow under a bidding procedure meeting
the requirements of the final regulations is taken into

[[Page 71750]]

account in determining the lowest cost bid.
The final regulations provide the following rules for comparing the
lowest cost bid to SLGs. First, the most efficient SLG portfolio
consists of one or more SLG securities that will allow the issuer to
defease the refunded obligations at the lowest overall cost. Second,
the comparison of the most efficient SLG portfolio and the lowest cost
bid must be made at the time that bids are required to be submitted
pursuant to the terms of the bid specifications. Intra-day pricing
movements and closing spot prices of investments before and after the
time in which the comparison to SLGs is required to be made are not
relevant. Third, if SLGs are not available for purchase on the day that
bids are required to be submitted pursuant to terms of the bid
specifications because Treasury has suspended sales of those
securities, the comparison of the most efficient SLG portfolio to the
lowest cost bid is not required.
No comparison to SLGs is required for purchases of guaranteed
investment contracts.

J. Forward Pricing Data

The proposed regulations provide that the yield on United States
Treasury obligations purchased by the issuer may not be significantly
less than the yield then available from the provider on reasonably
comparable United States Treasury obligations offered to other persons
for purchase on terms comparable to those offered to the issuer from a
source of funds other than tax-exempt bonds. If closely comparable
forward prices are not available, a reasonable basis for this
comparison may be by reference to implied forward prices for Treasury
obligations based on standard financial formulas. A certificate
provided by the agent conducting the bidding process will establish
that the comparison is met. The existing safe harbor for guaranteed
investment contracts provides that the yield on the guaranteed
investment contract may not be less than the yield then available from
the provider on reasonably comparable guaranteed investment contracts,
if any, offered to other persons from a source of funds other than
gross proceeds of tax-exempt bonds.
Commentators noted that, in general, the comparison required by the
proposed regulations is either too complex or not possible to
construct. In lieu of a comparability requirement, commentators
recommended that the regulations adopt certain additional safeguards to
protect the integrity of the bidding process.
The final regulations remove the comparability requirement for all
investments covered by the safe harbor. However, the final regulations
include additional requirements to ensure a competitive bidding
process. For example, the final regulations require that the bid form
forwarded to potential providers include a statement notifying
providers that by submitting a bid the potential provider is
representing that it did not consult with any other providers about
their bid, and that its bid is not being submitted solely as a courtesy
to the issuer or any other person for purposes of satisfying the
requirement that the issuer receive three bids. It is anticipated that
these additional requirements will ensure that the bids reflect fair
market value, as determined without regard to the source of funds.

K. Record Keeping Requirements

The proposed regulations provide that issuers are required to
retain certain records and information with the bond documents,
including a copy of the bids received (date and time stamped). Numerous
comments were received regarding the difficulty of obtaining written
bids for Treasury obligations.
The final regulations modify the record keeping requirements and
apply those requirements to guaranteed investment contracts. One
modification to the record keeping requirements is the elimination of
the requirement that the bids be received in writing. The final
regulations provide that the requirement for recording the bid is
satisfied if the issuer or its agent makes a contemporaneous record of
the bid, including the time and date each bid was received, and the
identification of the person and entity submitting the bid, and keeps
this record with the bond documents.
The final regulations also provide that, if the terms of the
purchase agreement deviate from the terms of the bid solicitation form
or if a submitted bid is modified, the issuer must keep a record
explaining the purpose of the deviation or modification and, if the
purchase agreement price differed from the bid, how that price was
determined. If the issuer replaces investments in the winning bid
portfolio with other investments, the prices of the new investments are
not protected by the safe harbor unless those investments are bid under
a bidding procedure meeting the requirements of the final regulations.

L. Broker Fees for Yield Restricted Defeasance Escrows

The proposed regulations provide that a fee paid to a bidding agent
is a qualified administrative cost only if the fee is comparable to a
fee that would be charged for a reasonably comparable investment of
obligations acquired with a source of funds other than gross proceeds
of tax-exempt bonds and the fee is reasonable. Under the proposed
regulations, the fee is presumed to be reasonable if it does not exceed
.02 percent of the amount invested in United States Treasury
obligations. Commentators noted that the comparability requirement was
unclear and that outside the context of municipal bonds, bidding for
closely comparable investments is virtually non-existent. Commentators
also noted that the .02 percent fee may result in too much compensation
in the case of large escrows and too little compensation in the case of
small escrows.
The final regulations retain the comparability and reasonableness
requirements. However, the final regulations provide that a broker's
fee will meet the reasonableness and comparability requirements if the
fee does not exceed the lesser of $10,000 or .1 percent of the initial
principal amount of investments purchased for the yield restricted
defeasance escrow.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that
these regulations do not have a significant economic impact on a
substantial number of small entities. This certification is based upon
the fact that the amount of time required to meet the record keeping
requirement of these final regulations, an estimated annual average of
1 hour per taxpayer, is small. Also, the regulations affect a small
number of taxpayers, approximately 1400 annually. Therefore, a
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the
Internal Revenue Code, the notice of proposed rulemaking preceding
these regulations was submitted to the Small Business Administration
for comment on its impact on small business.
Drafting information. The principal authors of these regulations
are David White and Rebecca Harrigal of the IRS Office of Chief Counsel
and Edwin G. Oswald of the Department of the Treasury. However, other
personnel from the IRS and the Treasury Department participated in
their development.

[[Page 71751]]

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.148-5 is amended as follows:
1. Paragraph (d)(6)(iii) is revised.
2. Paragraph (e)(2)(iv) is added.
The revision and addition read as follows:

Sec. 1.148-5 Yield and valuation of investments.

* * * * *
(d) * * *
(6) * * *
(iii) Safe harbor for establishing fair market value for guaranteed
investment contracts and investments purchased for a yield restricted
defeasance escrow. The purchase price of a guaranteed investment
contract and the purchase price of an investment purchased for a yield
restricted defeasance escrow will be treated as the fair market value
of the investment on the purchase date if all of the following
requirements are satisfied:
(A) The issuer makes a bona fide solicitation for the purchase of
the investment. A bona fide solicitation is a solicitation that
satisfies all of the following requirements:
(1) The bid specifications are in writing and are timely forwarded
to potential providers.
(2) The bid specifications include all material terms of the bid. A
term is material if it may directly or indirectly affect the yield or
the cost of the investment.
(3) The bid specifications include a statement notifying potential
providers that submission of a bid is a representation that the
potential provider did not consult with any other potential provider
about its bid, that the bid was determined without regard to any other
formal or informal agreement that the potential provider has with the
issuer or any other person (whether or not in connection with the bond
issue), and that the bid is not being submitted solely as a courtesy to
the issuer or any other person for purposes of satisfying the
requirements of paragraph (d)(6)(iii)(B)(1) or (2) of this section.
(4) The terms of the bid specifications are commercially
reasonable. A term is commercially reasonable if there is a legitimate
business purpose for the term other than to increase the purchase price
or reduce the yield of the investment. For example, for solicitations
of investments for a yield restricted defeasance escrow, the hold firm
period must be no longer than the issuer reasonably requires.
(5) For purchases of guaranteed investment contracts only, the
terms of the solicitation take into account the issuer's reasonably
expected deposit and drawdown schedule for the amounts to be invested.
(6) All potential providers have an equal opportunity to bid. For
example, no potential provider is given the opportunity to review other
bids (i.e., a last look) before providing a bid.
(7) At least three reasonably competitive providers are solicited
for bids. A reasonably competitive provider is a provider that has an
established industry reputation as a competitive provider of the type
of investments being purchased.
(B) The bids received by the issuer meet all of the following
requirements:
(1) The issuer receives at least three bids from providers that the
issuer solicited under a bona fide solicitation meeting the
requirements of paragraph (d)(6)(iii)(A) of this section and that do
not have a material financial interest in the issue. A lead underwriter
in a negotiated underwriting transaction is deemed to have a material
financial interest in the issue until 15 days after the issue date of
the issue. In addition, any entity acting as a financial advisor with
respect to the purchase of the investment at the time the bid
specifications are forwarded to potential providers has a material
financial interest in the issue. A provider that is a related party to
a provider that has a material financial interest in the issue is
deemed to have a material financial interest in the issue.
(2) At least one of the three bids described in paragraph
(d)(6)(iii)(B)(1) of this section is from a reasonably competitive
provider, within the meaning of paragraph (d)(6)(iii)(A)(7) of this
section.
(3) If the issuer uses an agent to conduct the bidding process, the
agent did not bid to provide the investment.
(C) The winning bid meets the following requirements:
(1) Guaranteed investment contracts. If the investment is a
guaranteed investment contract, the winning bid is the highest yielding
bona fide bid (determined net of any broker's fees).
(2) Other investments. If the investment is not a guaranteed
investment contract, the following requirements are met:
(i) The winning bid is the lowest cost bona fide bid (including any
broker's fees). The lowest cost bid is either the lowest cost bid for
the portfolio or, if the issuer compares the bids on an investment-by-
investment basis, the aggregate cost of a portfolio comprised of the
lowest cost bid for each investment. Any payment received by the issuer
from a provider at the time a guaranteed investment contract is
purchased (e.g., an escrow float contract) for a yield restricted
defeasance escrow under a bidding procedure meeting the requirements of
this paragraph (d)(6)(iii) is taken into account in determining the
lowest cost bid.
(ii) The lowest cost bona fide bid (including any broker's fees) is
not greater than the cost of the most efficient portfolio comprised
exclusively of State and Local Government Series Securities from the
United States Department of the Treasury, Bureau of Public Debt. The
cost of the most efficient portfolio of State and Local Government
Series Securities is to be determined at the time that bids are
required to be submitted pursuant to the terms of the bid
specifications.
(iii) If State and Local Government Series Securities from the
United States Department of the Treasury, Bureau of Public Debt are not
available for purchase on the day that bids are required to be
submitted pursuant to terms of the bid specifications because sales of
those securities have been suspended, the cost comparison of paragraph
(d)(6)(iii) (C)(2)(ii) of this section is not required.
(D) The provider of the investments or the obligor on the
guaranteed investment contract certifies the administrative costs that
it pays (or expects to pay, if any) to third parties in connection with
supplying the investment.
(E) The issuer retains the following records with the bond
documents until three years after the last outstanding bond is
redeemed:
(1) For purchases of guaranteed investment contracts, a copy of the
contract, and for purchases of investments other than guaranteed
investment contracts, the purchase agreement or confirmation.
(2) The receipt or other record of the amount actually paid by the
issuer for the investments, including a record of

[[Page 71752]]

any administrative costs paid by the issuer, and the certification
under paragraph (d)(6)(iii)(D) of this section.
(3) For each bid that is submitted, the name of the person and
entity submitting the bid, the time and date of the bid, and the bid
results.
(4) The bid solicitation form and, if the terms of the purchase
agreement or the guaranteed investment contract deviated from the bid
solicitation form or a submitted bid is modified, a brief statement
explaining the deviation and stating the purpose for the deviation. For
example, if the issuer purchases a portfolio of investments for a yield
restricted defeasance escrow and, in order to satisfy the yield
restriction requirements of section 148, an investment in the winning
bid is replaced with an investment with a lower yield, the issuer must
retain a record of the substitution and how the price of the substitute
investment was determined. If the issuer replaces an investment in the
winning bid portfolio with another investment, the purchase price of
the new investment is not covered by the safe harbor unless the
investment is bid under a bidding procedure meeting the requirements of
this paragraph (d)(6)(iii).
(5) For purchases of investments other than guaranteed investment
contracts, the cost of the most efficient portfolio of State and Local
Government Series Securities, determined at the time that the bids were
required to be submitted pursuant to the terms of the bid
specifications.
(e) * * *
(2) * * *
(iv) Special rule for investments purchased for a yield restricted
defeasance escrow. For investments purchased for a yield restricted
defeasance escrow, a fee paid to a bidding agent is a qualified
administrative cost only if the following requirements are satisfied:
(A) The fee is comparable to a fee that would be charged for a
reasonably comparable investment if acquired with a source of funds
other than gross proceeds of tax-exempt bonds, and it is reasonable.
The fee is deemed to be comparable to a fee that would be charged for a
comparable investment acquired with a source of funds other than gross
proceeds of tax-exempt bonds, and to be reasonable if the fee does not
exceed the lesser of $10,000 or .1% of the initial principal amount of
investments deposited in the yield restricted defeasance escrow.
(B) For transactions in which a guaranteed investment contract and
other investments are purchased for a yield restricted defeasance
escrow in a single investment (e.g., an issuer bids United States
Treasury obligations and an escrow float contract collectively), a
broker's fee described in paragraph (e)(2)(iv)(A) of this section will
apply to the initial principal amount of the investment deposited in
the yield restricted defeasance escrow, and a broker's fee described in
paragraph (e)(2)(iii) of this section will apply only to the guaranteed
investment contract portion of the investment.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805.

Par. 4. In Sec. 602.101, paragraph (c) is amended by revising the
entry for 1.148-5 in the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *
(c) * * *

------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------

* * * * *
1.148-5................................................. 1545-1098,
1545-1490

* * * * *
------------------------------------------------------------------------

Approved: December 17, 1998.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 98-34209 Filed 12-29-98; 8:45 am]
BILLING CODE 4830-01-U