Arbitrage Restrictions on Tax-Exempt Bonds

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8801] RIN 1545-
AU39

TITLE: Arbitrage Restrictions on Tax-Exempt Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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 §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 §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 §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.

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 A 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.10 float contract) for a yield restricted defeasance escrow
under a bidding procedure meeting the requirements of the final
regulations is taken into 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.

List of Subjects

26 CFR Part 1.15 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:

§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.19 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 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 §602.101, paragraph (c) is amended by revising the entry
for 1.148-5 in the table to read as follows:

§602.101 OMB Control numbers.

* * * * *

(c) * * *

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

* * * * *

1.148-5.......................................1545-1098

1545-1490

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: December 17, 1998
Donald C. Lubick
Assistant Secretary of the Treasury

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