Qualified Zone Academy Bonds

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8755] RIN 1545-AV74

TITLE: Qualified Zone Academy Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations relating to
the federal income tax treatment of qualified zone academy bonds.
The regulations in this document provide needed guidance to holders
and issuers of qualified zone academy bonds. The text of the
temporary regulations also serves as the text of the proposed
regulations set forth in the notice of proposed rulemaking on this
subject in the Proposed Rules section of this issue of the Federal
Register.

DATES: These regulations are effective January 1, 1998.

FOR FURTHER INFORMATION CONTACT: Timothy L. Jones, (202) 622- 3980
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 226(a) of the Taxpayer Relief Act of 1997, Pub. L.

No. 105-34, 111 Stat. 788 (1997), amended the Internal Revenue Code
(Code) by redesignating section 1397E as section 1397F and adding a
new section 1397E. Section 1397E authorizes a new type of debt
instrument known as a qualified zone academy bond.

Explanation of provisions In general A qualified zone academy bond
is a taxable bond issued by a state or local government the proceeds
of which are used to improve certain eligible public schools. In
lieu of receiving periodic interest payments from the issuer, an
eligible holder of a qualified zone academy bond is generally
allowed annual federal income tax credits while the bond is
outstanding. These credits compensate the holder for lending money
to the issuer and function as payments of interest on the bond.

These temporary regulations provide rules for the federal income tax
treatment of qualified zone academy bonds. These regulations
generally treat the allowance of the credit as if it were a payment
of interest on the bond. These regulations also provide rules to
determine (1) the credit rate, (2) the discount rate used to present
value private business contributions, and (3) the discount rate used
to determine the maximum term of a qualified zone academy bond.

These regulations generally do not provide guidance on the statutory
requirements that must be met for a bond to qualify as a qualified
zone academy bond. Section 1397E(d) sets forth a number of detailed
requirements that must be met for a bond to qualify as a qualified
zone academy bond. In particular, section 1397E(d)(1)(C) requires
the issuer to certify (1) that it has written assurances that
private entities have agreed to contribute a certain level of goods
or services to the qualified zone academy, and (2) that it has the
written approval of the eligible local education agency for the bond
issuance. The Treasury and the IRS intend that these certifications
will be respected and may be relied on by taxpayers if the
certifications are reasonably made.

In addition, section 1397E(d)(1)(A) requires that 95 percent or more
of the proceeds of an issue of qualified zone academy bonds are to
be used for a qualified purpose described in section 1397E(d)(5)
with respect to a qualified zone academy as defined in section
1397E(d)(4). The Treasury and the IRS intend that the qualified
purposes set forth in section 1397E(d)(5) are to be broadly
interpreted. The Treasury and the IRS also intend that, if an issuer
is unable to actually spend 95 percent or more of the proceeds of a
qualified zone academy bond for a qualified purpose, the issuer may
apply remedial actions similar to the remedial actions set forth in
§1.142-2 to preserve the qualification of a bond. Further, the
Treasury and the IRS intend that taxpayers may rely on an issuer's
determination that a public school (or academic program within a
public school) is a qualified zone academy for purposes of section
1397E(d)(4) if the determination has a reasonable basis. The
Treasury and IRS request comments on whether additional guidance is
needed with respect to the section 1397E(d) requirements.

Section 1397E(e) imposes a national limitation on the amount of
qualified zone academy bonds that can be issued. For 1998 and 1999,
the IRS will publish a revenue procedure allocating the national
limitation among the States and the possessions.

The credit allowance

A qualified zone academy bond provides an annual federal income tax
credit to certain holders. Under the regulations, the credit is
deemed paid on the credit allowance date--the last day of each one-
year accrual period on the bond. A taxpayer that receives a credit
on a credit allowance date may use the credit to offset its income
tax liability for the taxable year that includes the credit
allowance date.

There are two limitations on the use of the credit. First, only
eligible taxpayers holding the bond on the credit allowance date may
claim the credit. Section 1397E(d)(6) defines an eligible taxpayer
as a bank, an insurance company, or a corporation actively engaged
in the business of lending money.

Second, an eligible taxpayer may claim the credit only to the extent
the taxpayer has a tax liability for the taxable year that includes
the credit allowance date. See section 1397E(c). The credit is
nonrefundable.

Treatment of the credit as interest

The regulations treat the credit on a qualified academy zone bond as
if it were a payment of qualified stated interest. This treatment
effectively conforms the treatment of the credit with the treatment
of interest income on debt instruments. Thus, for example, a holder
that uses an accrual method of accounting accrues the credit amount
over the one-year accrual period that ends on the credit allowance
date.

Adjustment when credit is limited or disallowed

In two situations the holder of a qualified zone academy bond on a
credit allowance date will not be able to use some or all of the
credit to offset its tax liability. First, if the holder on a credit
allowance date is not an eligible taxpayer (a bank, insurance
company, or corporation actively engaged in the business of lending
money), no credit is allowed. Second, the amount of the credit may
exceed the income tax liability of a holder that is an eligible
taxpayer. In this second case, because the credit is nonrefundable,
some or all of the credit will not be used.

In these situations, the regulations allow the holder to adjust its
income by deducting the amount of the unused credit.

This deduction is allowed for the taxable year that includes the
credit allowance date. The Treasury and the IRS request comments on
whether this adjustment works appropriately when an eligible
taxpayer holds a qualified zone academy bond on the credit allowance
date but has an income tax liability (determined without regard to
the credit) that is less than the amount of the credit.

Credit rate

Section 1397E(b)(2) authorizes the Treasury to establish a single,
uniform credit rate that will permit the issuance of qualified zone
academy bonds without discount and without interest cost to the
issuer. This section also requires the Treasury to adjust the credit
allowance rate on a monthly basis to reflect changes in market
interest rates.

It is not possible to determine a uniform credit rate that would
permit all qualified zone academy bonds to be issued at par. Some
borrowers are less creditworthy than others and, therefore, borrow
at less favorable rates. In addition, because section 1397E(b)(2)
requires the Secretary to set the credit rate in the month before
the bond is issued, changes in market interest rates between the
time the rate is set and the time a qualified zone academy bond is
issued can result in a bond being issued at a price that is
different than par.

The regulations provide a single monthly rate that will minimize the
discount or premium on qualified zone academy bonds. Specifically,
the regulations provide that the credit rate is 110 percent of the
long-term applicable Federal rate (AFR), compounded annually, for
the month of issuance. Tying the credit rate to the AFR ensures that
the rate will be adjusted on a monthly basis to reflect changes in
market interest rates. In addition, the Treasury and the IRS believe
the 10 percent spread over the long-term AFR is appropriate, in
part, because qualified zone academy bonds bear more credit and
liquidity risk than long-term Treasury bonds.

Maximum term

Section 1397E(d)(3) sets out a formula for determining the maximum
term of a qualified zone academy bond. The formula requires the use
of a discount rate equal to the average annual interest rate of tax-
exempt obligations having a term of ten years or more. Because there
is no readily available source for this discount rate, the
regulations provide that the discount rate is 110 percent of the
long-term adjusted AFR, compounded semi-annually. The long-term
adjusted AFR is published on a monthly basis and is designed to
reflect the current yield of a risk-free tax-exempt obligation
having a term of 9 years or more.

Taxable obligation

It is possible that some qualified zone academy bonds may either (1)
provide for payments of stated interest, or (2) be issued at a
discount. The Treasury and the IRS have determined that qualified
zone academy bonds are not obligations the interest on which is
excluded from gross income under section 103(a). There are a number
of reasons for treating a qualified zone academy bond as a taxable
obligation. For example, the requirement in section 1397E(g) that a
holder include the allowed amount of the credit in gross income
evidences an intention to treat qualified zone academy bonds as
taxable, not tax-exempt, obligations.

Coordination with estimated tax rules

The regulations do not address the estimated tax consequences of
holding a qualified zone academy bond. The Treasury and the IRS
request comments on whether there is a need to coordinate the
regulations with the estimated tax rules and, if so, how they might
be coordinated.

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 also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations and, because the
regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to section 7805(f) of the
Internal Revenue Code, these temporary regulations will be submitted
to the Chief Counsel for Advocacy of the Small Business
Administration for comment on their impact on small business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury
Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1 Income taxes, Reporting and
recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:

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

Section 1.1397E-1T also issued under 26 U.S.C. 1397E(b) and
1397E(d). * * *

Par. 2. Section 1.1397E-1T is added to read as follows:

§1.1397E-1T Qualified zone academy bonds (temporary).

(a) Overview. In general, a qualified zone academy bond is a taxable
bond issued by a state or local government the proceeds of which are
used to improve certain eligible public schools. An eligible
taxpayer that holds a qualified zone academy bond generally is
allowed annual federal income tax credits in lieu of periodic
interest payments. These credits compensate the eligible taxpayer
for lending money to the issuer and function as payments of interest
on the bond. Accordingly, this section generally treats the
allowance of a credit as if it were a payment of interest on the
bond. In addition, this section provides rules to determine the
credit rate, the present value of qualified contributions from
private entities, and the maximum term of a qualified zone academy
bond.

(b) Credit rate. The credit rate for a qualified zone academy bond
is equal to 110 percent of the long-term applicable Federal rate
(AFR), compounded annually, for the month in which the bond is
issued. The Internal Revenue Service publishes this figure each
month in a revenue ruling that is published in the Internal Revenue
Bulletin. See §601.601(d)(2)(ii)(b) of this Chapter.

(c) Private business contribution requirement. To determine the
present value (as of the issue date) of qualified contributions from
private entities under section 1397E(d)(2), the issuer must use a
reasonable discount rate. The credit rate determined under paragraph
(b) of this section is a reasonable discount rate.

(d) Maximum term. The maximum term for a qualified zone academy bond
is determined under section 1397E(d)(3) by using a discount rate
equal to 110 percent of the long-term adjusted AFR, compounded semi-
annually, for the month in which the bond is issued. The Internal
Revenue Service publishes this figure each month in a revenue ruling
that is published in the Internal Revenue Bulletin. See §601.601(d)
(2)(ii)(b) of this Chapter.

(e) Tax credit--(1) Eligible taxpayer. An eligible taxpayer (within
the meaning of section 1397E(d)(6)) that holds a qualified zone
academy bond on a credit allowance date is allowed a tax credit
against the federal income tax imposed on the taxpayer for the
taxable year that includes the credit allowance date. The amount of
the credit is equal to the product of the credit rate and the
outstanding principal amount of the bond on the credit allowance
date. The credit is subject to a limitation based on the eligible
taxpayer's income tax liability. See section 1397E(c).

(2) Ineligible taxpayer. A taxpayer that is not an eligible taxpayer
is not allowed a credit.

(f) Treatment of the allowance of the credit as a payment of
interest--(1) General rule. The holder of a qualified zone academy
bond must treat the bond as if it pays qualified stated interest
(within the meaning of §1.1273-1(c)) on each credit allowance date.
The amount of the deemed payment of interest on each credit
allowance date is equal to the product of the credit rate and the
outstanding principal amount of the bond on that date. Thus, for
example, if the holder uses an accrual method of accounting, the
holder must accrue as interest income the amount of the credit over
the one-year accrual period that ends on the credit allowance date.

(2) Adjustment if the holder cannot use the credit to offset a tax
liability. If a holder holds a qualified zone academy bond on the
credit allowance date but cannot use all or a portion of the credit
to reduce its income tax liability (for example, because the holder
is not an eligible taxpayer or because the limitation in section
1397E(c) applies), the holder is allowed a deduction for the taxable
year that includes the credit allowance date. The amount of the
deduction is equal to the amount of the unused credit deemed paid on
the credit allowance date.

(g) Not a tax-exempt obligation. A qualified zone academy bond is
not an obligation the interest on which is excluded from gross
income under section 103(a).

(h) Cross-references. See section 171 and the regulations thereunder
for rules relating to amortizable bond premium. See §1.61-7(c) for
the seller's treatment of a bond sold between interest payment dates
(credit allowance dates) and §1.61-7(d) for the buyer's treatment of
a bond purchased between interest payment dates (credit allowance
dates).

(i) [Reserved]

(j) Effective date. This section applies to a qualified zone academy
bond issued on or after January 1, 1998.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: Donald C. Lubick
Acting Assistant Secretary of the Treasury

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