Arbitrage Restrictions Applicable to Tax-Exempt
Bonds Issued by State & Local Governments

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-105565-99] RIN 1545-AX22

TITLE: Arbitrage Restrictions Applicable to Tax-exempt Bonds Issued
by State and Local Governments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations on the
arbitrage restrictions applicable to tax-exempt bonds issued by
State and local governments. The proposed amendments affect issuers
of tax-exempt bonds and provide a safe harbor for qualified
administrative costs for brokers' commissions and similar fees
incurred in connection with the acquisition of a guaranteed
investment contract or investments purchased for a yield restricted
defeasance escrow.

DATES: Written comments must be received by November 26, 1999.

Outlines of topics to be discussed at the public hearing scheduled
for December 14, 1999, at 10 a.m. must be received by Tuesday,
November 23, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-105565-99), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to
CC:DOM:CORP:R (REG-105565-99), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue, NW., Washington, DC.

Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the A Tax Regs @ option on the IRS Home Page,
or by submitting comments directly to the IRS site at
http://www.irs.ustreas.gov/tax_regs/regslist.html. The public
hearing is in the Auditorium, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Rose M. Weber, (202) 622-3980; concerning submissions
of comments, the hearing, and/or requests to be placed on the
building access list to attend the hearing, Michael Slaughter, (202)
622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 148 of the Internal Revenue Code provides rules addressing
the use of proceeds of tax-exempt State and local bonds to acquire
higher-yielding investments. On May 9, 1997, final regulations (TD
8718) relating to the arbitrage restrictions and related rules under
sections 103, 148, 149, and 150 were published in the Federal
Register (62 FR 25502). The final regulations (TD 8718) were amended
on December 30, 1998 (63 FR 71748). This document proposes to modify
§1.148-5(e)(2) to provide a safe harbor for determining whether
brokers' commissions and similar fees incurred in connection with
the acquisition of guaranteed investment contracts or investments
purchased for a yield restricted defeasance escrow are treated as
qualified administrative costs.

Explanation of Provisions

Section 1.148-5(e)(2)(iii) and (iv) of the regulations provides
rules for determining whether a broker's commission or similar fee
is treated as a qualified administrative cost.

Section 1.148-5(e)(2)(iii) provides that, for a guaranteed
investment contract, a broker's commission or similar fee paid on
behalf of either an issuer or the provider is treated as an
administrative cost and, generally, is a qualified administrative
cost to the extent that the present value of the commission, as of
the date the contract is allocated to the issue, does not exceed the
lesser of a reasonable amount or the present value of annual
payments equal to .05 percent of the weighted average amount
reasonably expected to be invested each year of the term of the
contract. Present value is computed using the taxable discount rate
used by the parties to compute the commission, or if not readily
ascertainable, the yield to the issuer on the investment contract or
other reasonable taxable discount rate.

Section 1.148-5(e)(2)(iv) provides that, for investments purchased
for a yield restricted defeasance escrow, 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 if acquired with a source of funds other than
gross proceeds of tax-exempt bonds, and it is reasonable.

The fee is deemed to meet both the comparability and reasonableness
requirements if it does not exceed the lesser of $10,000 and .1
percent of the initial principal amount of investments deposited in
the yield restricted defeasance escrow.

Unlike §1.148-5(e)(2)(iv), §1.148-5(e)(2)(iii) does not provide
parameters under which the reasonableness test will be deemed to
have been met. Practitioners have noted that they are uncertain
about how to determine reasonableness and whether the .05% test may
be used as a safe harbor without regard to whether the resulting
amount is a reasonable fee.

Practitioners have also noted that the computation required by
§1.148-5(e)(2)(iii) is too complex and results in different fees
being paid for the same services provided.

Finally, having different rules for guaranteed investment contracts
and investments purchased for a yield restricted defeasance escrow
provides an unnecessary tax incentive to structure investments in a
certain manner.

To eliminate these complexities and to provide a rule that is easily
administered by issuers, the proposed regulations create a single
rule for qualified administrative costs that applies to a broker's
commission or similar fee incurred in connection with a guaranteed
investment contract or investments purchased for a yield restricted
defeasance escrow. The proposed regulations also set forth a safe
harbor, which allows a broker's commission or similar fee incurred
in connection with the acquisition of a guaranteed investment
contract or investments purchased for a yield restricted defeasance
escrow to be treated as a qualified administrative cost. To fairly
compensate most brokers, the proposed safe harbor provides a higher
safe harbor limit than is currently provided for in §1.148-5(e)(2)
(iv).

The proposed safe harbor sets forth two requirements. Under the
first requirement, the amount of the broker's commission or similar
fee incurred in connection with the acquisition of a guaranteed
investment contract or other investments purchased for a yield
restricted defeasance escrow and treated by the issuer as a
qualified administrative cost cannot exceed the lesser of $25,000
and .2 percent of the computational base. For guaranteed investment
contracts, the computational base is the aggregate amount reasonably
expected to be deposited over the term of the contract. For
investments, other than guaranteed investment contracts, deposited
in a yield restricted defeasance escrow, the computational base is
the initial amount invested in those investments. For example, for a
guaranteed investment contract purchased for a debt service fund,
the aggregate amount reasonably expected to be deposited includes
all periodic deposits reasonably expected to be made pursuant to the
terms of the contract. Under the second requirement, for any issue
of bonds, the issuer cannot treat as qualified administrative costs
more than $75,000 in brokers' commissions and similar fees with
respect to all guaranteed investment contracts and investments for
yield restricted defeasance escrows purchased with gross proceeds of
the issue.

The proposed regulations eliminate the special rule in §1.148-5(e)
(2)(iii) for issues that meet section 148(f)(4)(D)(i).

These bond issues will be permitted to use the safe harbor.

These regulations are proposed to apply to bonds sold on or after
the date 90 days after the issuance of the final regulations.

Special Analysis

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not required.

It has also 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, this notice of
proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its
impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic and written comments
(a signed original and eight (8) copies, if written) that are
submitted timely to the IRS. In particular, the IRS and Department
of Treasury specifically request comments on the clarity of the
proposed rule and how it may be made easier to understand. All
comments will be available for public inspection and copying.

A public hearing has been scheduled for Tuesday, December 14, 1999,
beginning at 10 a.m. in the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC.

Due to building security procedures, visitors must enter at the 10
Street entrance, located between Constitution and th Pennsylvania
Avenues, NW. In addition, all visitors must present photo
identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate
entrance area more than 15 minutes before the hearing starts.

For information about having your name placed on the building access
list to attend the hearing, see the A FOR FURTHER INFORMATION
CONTACT @ section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit
written comments by November 26, 1999, and submit an outline of the
topics to be discussed and the time to be devoted to each topic
(signed original and eight (8) copies) by November 23, 1999. A
period of 10 minutes will be allotted to each person for making
comments. An agenda showing the scheduling of speakers will be
prepared after the deadline for receiving outlines has passed.
Copies of the agenda will be available free of charge at the
hearing.

Drafting Information

The principal authors of these proposed regulations are Rose M.
Weber and Rebecca L. Harrigal, Office of the Assistant Chief Counsel
(Financial Institutions & Products). However, other personnel from
the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows:

PART 1 B 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. In §1.148-5, paragraph (e) is amended as follows:

1. Paragraph (e)(2)(iii) is revised.

2. Paragraph (e)(2)(iv) is removed.

The revision reads as follows:

§1.148-5 Yield and valuation of investments.

* * * * *

(e) * * *

(2) * * *

(iii) Special rule for guaranteed investment contracts and
investments purchased for a yield restricted defeasance escrow--

(A) In general. An amount paid for a broker's commission or similar
fee with respect to a guaranteed investment contract or investments
purchased for a yield restricted defeasance escrow is a qualified
administrative cost if the fee is reasonable within the meaning of
paragraph (e)(2)(i) of this section.

(B) Safe harbor. (1) A broker's commission or similar fee with
respect to the acquisition of a guaranteed investment contract or
investments purchased for a yield restricted defeasance escrow is
reasonable within the meaning of paragraph (e)(2)(i) of this section
if--

(i) The amount of the fee that the issuer treats as a qualified
administrative cost does not exceed the lesser of $25,000 and .2% of
the computational base; and

(ii) For any issue, the issuer does not treat as qualified
administrative costs more than $75,000 in brokers' commissions or
similar fees with respect to all guaranteed investment contracts and
investments for yield restricted defeasance escrows purchased with
gross proceeds of the issue.

(2) For purposes of paragraph (e)(2)(iii)(B)(1) of this section,
computational base shall mean--

(i) For a guaranteed investment contract, the amount the issuer
reasonably expects as of the issue date to be deposited in the
guaranteed investment contract over the term of the contract; and

(ii) For investments (other than guaranteed investment contracts) to
be deposited in a yield restricted defeasance escrow, the amount of
gross proceeds initially invested in those investments.

(C) Example. The following example illustrates an application of the
safe harbor in paragraph (e)(2)(iii)(B) of this section:

Example. The issuer of a multipurpose issue uses brokers to purchase
the following investments with gross proceeds of the issue: a
guaranteed investment contract for amounts to be deposited in a debt
service fund (debt service GIC), a guaranteed investment contract
for amounts to be deposited in a construction fund (construction
GIC), Treasury securities to be deposited in a yield restricted
defeasance escrow (Treasury investments) and a guaranteed investment
contract that will be used to earn a return on what would otherwise
be idle cash balances from maturing investments in the yield
restricted defeasance escrow (the float GIC). The issuer uses
$8,040,000 of the proceeds to purchase the Treasury investments and
deposits $14,000,000 into the construction GIC. Over the term of the
construction GIC, the issuer reasonably expects that no further
deposits will be made.

Over the term of the float GIC, the issuer reasonably expects that
aggregate deposits of $600,000 will be made to the float GIC. Over
the term of the debt service GIC, the issuer reasonably expects that
it will make aggregate deposits of $22,000,000, plus interest on the
bond issue. The brokers' fees do not exceed $16,080 for the Treasury
investments, $25,000 for the construction GIC, $1,200 for the float
GIC, and $25,000 for the debt service GIC. Assuming the issuer
claims no further brokerage or similar fees, the issuer can claim
all $67,280 in brokerage fees for these investments as qualified
administrative costs because the fees do not exceed the limitations
described in paragraph (e)(2)(iii)(B) of this section.

* * * * *

Robert E. Wentzel
Deputy Commissioner of Internal Revenue.

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