WASHINGTON - Bond lawyers have mixed views about new "replacement" rules that are designed to prevent states and localities from issuing tax-exempt bonds for projects that could have been paid for with other funds that are being kept free for investment.
The rules are part of the new arbitrage regulations that were published on June 14 and that generally took effect for bonds issued after June 30.
Under the replacement rules, certain funds that an issuer or borrower has on hand may be treated as replacing bond proceeds and become subject to the same yield restriction or rebate requirements as the bond proceeds.
In one example, a nonprofit university solicits and obtains gifts of money for a sports stadium. The university also borrows tax-exempt bond proceeds to finance the stadium. It spends the bond proceeds on the stadium but invests the gifts of money to earn profits. In this case, the gifts of money would be treated as replacing the bond proceeds and would have to be invested at a yield that does not exceed the bond yield.
Many of the lawyers said last week that the new replacement rules are well-written and provide much-needed guidance on the concept of replacement, which has been in the tax law since 1969 but never defined in regulations.
They praised the IRS for tackling a difficult subject that until now had only been dealt with in a few agency revenue rulings.
"They did a good job of taking all of the published rulings and distilling their essence," said Perry E. Israel, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco.
"I think a lot of what they did in terms of incorporating the revenue rulings in these rules was right on the mark," agreed Robert W. Buck, a lawyer with Palmer & Dodge in Boston.
But some of the lawyers are concerned about the so-called safe harbors included in the rules, which set forth conditions under which bond issues will be in compliance with one of the main replacement rules.
The safe harbors may be so limited that some issuers will have trouble falling within them, they said.
"I'm not sure they are can be administered" in some cases, said Buck.
At the same time, however, a number of lawyers cautioned against viewing the safe harbors as requirements.
"If some people want to sail outside of the safe harbors and feel comfortable doing that, they can do it. The safe harbors only say you're bullet proof," said Israel.
The new rules define replacement proceeds as funds that have enough of a "direct nexus to the issue or to the governmental purpose of the issue" that one could "conclude that the [funds] would have been used for that governmental purpose" if the proceeds of the issue were not.
Replacement proceeds would include, but would not be limited to, sinking funds or pledged funds that are directly or indirectly used to pay principal or interest on a bond issue. These funds could be held by an issuer or by another party that substantially benefits from the issue, according to the rules.
Bonds Out Too Long
The concerns raised by some lawyers stem from provisions of the rules that say "other replacement proceeds" may arise when bonds remain outstanding longer than is "reasonably necessary" to serve the governmental purpose and the issuer or borrower has other funds available during that time.
In other words, if an issuer were to issue 10-year bonds to finance new police cars that it expected to use for only four years, and the issuer had surpluses in its general fund during that period, the surpluses would be treated as replacing the bond proceeds and would be subject to yield restriction or rebate requirements.
Issuers or borrowers could have trouble determining if their bonds have been outstanding longer than necessary or if they have other funds available.
The rules contain three safe harbors, under which bond issues that meet certain conditions will not be treated as being outstanding longer than necessary so that issuers are less likely to have a replacement proceeds problem.
The first safe harbor is for working capital financings that are not outstanding for more than two years.
Issuers doing short-term cash-flow financings to cover temporary cash imbalances would not have trouble meeting this safe harbor because their issues are typically not outstanding for more than 13 months, the lawyers said.
However, the safe harbor could be out of reach for issuers doing longer-term bond issues to finance structural deficits or court-ordered payments, as in liability or environmental lawsuits.
The second safe harbor is for capital financings whose weighted average maturity does not exceed 120% of the "average reasonably expected economic life" of the project being financed.
Federal regulatory officials said this week that they intend to allow this safe harbor to be applied to refundings as well as to new-money capital financings.
Safe Harbor Draws Concern
This safe harbor has drawn the most concerns because it applies a concept to governmental bonds that heretofore has only been applied to private-activity bonds.
"Their motives were probably very good," Buck said, referring to the drafters of the rules. "This is a test that everyone has used for private-activity bonds so they probably figured, why not, used it here since everyone is already, familiar with it. But governments do things differently than private businesses," he said.
One example of this is that while businesses depreciate their assets for tax purposes, governments do not, he said.
He and others worried that the safe harbor will not be available for some governmental issuers, particularly large issuers who periodically issue a large, single bond issue to finance dozens of projects.
"A large state borrower may issue bonds to cover a huge, almost endless list of assets, some of which may not be easily identifiable, or if you can identify, may not be easily assigned an average useful economic life." said Buck. "It could be an overwhelming task" to try to do this, he said.
But some of the lawyers said the safe harbor would not be a problem.
William L. Henn Jr., a lawyer with Piper & Marbury in Baltimore, said that Maryland and many other states already have laws prohibiting issuers from borrowing for a period that is longer than the economic life of the assets being financed.
The third safe harbor-applies for refundings in which the weighted average maturity of the refunding bonds does not exceed the remaining weighted average maturity of the bonds being refunded and the bonds being refunded met one of the other two safe harbors.
David A. Caprera, a lawyer with Kutak Rock in Denver, said issuers doing refundings may no longer have the documentation needed to verify that their earlier bonds met the safe harbor for capital financings.
But Caprera and other lawyers stressed that the safe harbors are not requirements and should not deter financings that do not meet them but that are not abusive.
"I think there will be a significant number of transactions which will be done, and should be done, that will not satisfy the safe harbors," said Caprera. "I do not feel constrained by the safe harbors."
