WASHINGTON - Bond market participants praised the Internal Revenue Service and the Treasury this week for producing a single set of arbitrage rules that will vastly simplify the regulation of tax-exempt bonds and give state and local issuers more flexibility in complying with federal arbitrage requirements.
The rules were published in final form on June 14, only about a year after IRS and Treasury officials first began consolidating and, simplifying several sets of arbitrage rules, some of which had been in effect since 1979.
"We have now, for the first time in years, a uniform single set of integrated regulations" that "are an improvement over prior rules" and that can be used "to determine the government's position or interpretation" on arbitrage questions, said David A. Caprera, a lawyer with Kutak Rock in Denver, who is preparing the National Association of Bond Lawyers' comments on the new rules.
"It's going to be a tremendous benefit to issuers." agreed Terence P. Burke, a vice president with First Southwest Co. in Dallas.
Burke said the consolidated rules will simplify compliance for both large issuers, who have had the money to set up their own arbitrage compliance programs. and small issuers, who have not been able to afford arbitrage experts. Until now, these issuers typically had to read three separate sets of rules to comply with arbitrage requirements, he said.
Market participants praised the IRS for including several effective dates in the new rules that give issuers a chance to study the rules and minimize the possibility of bond deals being rushed to market."
"They've given people a chance to get used to the new rules without a sudden switch over," said Robert W. Buck, a lawyer with Palmer & Dodge in Boston. "I think they've avoided a huge rush to market."
The rules generally took effect for bonds issued after June 30. But to prevent disruption of ongoing transactions, the IRS said issuers could continue using the existing rules until Aug. 15. In addition, the IRS said most of the new rules also could be applied retroactively to outstanding bonds.
Most market participants predicted that issuers will apply the new rules to their outstanding bond issues because they are a vast improvement over the previous rules, particularly those issued in 1989 and criticized as being too restrictive.
"They've done a good job simplifying" the earlier rules and have "eliminated the lion's share of ambiguities and complications" that existed, said William H. Connor, a lawyer with Squire. Sanders & Dempsey in Cleveland.
Bond lawyers, investment bankers. and issuers said the new rules generally are fair and evenhanded and will significantly reduce the arbitrage regulatory burdens on state and local issuers.
Most lawyers and investment bankers predicted that a greater number of issuers win be exempt from rebate requirements under the rules' new 18-month spending exception. This exempts issuers from rebate if they spend most of their bond proceeds according to six-month spending targets over an 18-month period.
"I think a fair number of issuers are going to be able to take advantage of this," said Buck. Until now, many issuers could not spend money quickly enough to qualify for the tax law's six-month spending exception to rebate and could not qualify for a complex statutory two-year spending exception that was limited to project financings.
Issuers also will be greatly helped by provisions that will allow them to make payments to adjust their bond yields downward to avoid earning arbitrage that would have to be rebated to the government.
These provisions, which were designed to help integrate yield restriction and rebate requirements, will be particularly beneficial to issuers who do not spend all of their proceeds in three years of who do not realize that after three years they may have to restrict the yield on the investments of their bond proceeds. Buck said.
Under the tax law, issuers financing projects typically are allowed to earn arbitrage for three-year periods, but the arbitrage must be rebated if their bonds are subject to rebate requirements. After the three-year period, the yield on the unspent bond proceeds must be no higher than the bond yield.
The yield-reduction payments will also be helpful for variable-rate bonds, whose yields are always changing, Buck said.
Richard Chirls, a lawyer with Orrick, Herrington & Sutcliffe in New York, said the payments win "help minimize yield-burning," a term used to describe situations in which an issuer pays a lot for an investment agreement with unnecessary special features to obtain a reduced rate of return and avoid arbitrage earnings.
Connor, however, said that while the idea of yield-adjustment payments "is eminently sensible," it "didn't go far enough." He said he was "disappointed" that the concept was not extended to advance refundings.
"That would have permitted variable-rate advance refundings, which we've never been able to do," he said.
Catherine Spain, director of the Government Finance Officers Association's federal liaison center, said the IRS and Treasury "were very responsive" in writing final rules that addressed issuers' "most troubling concerns."
"They really listened to what we said," agreed Burke.
The rules, for example, do not include earlier proposed anti-abuse provisions that were vigorously opposed by issuers and bond lawyers. The proposed provisions contained a broad new anti-abuse standard and would have required issuers' arbitrage certificates for bond issues to contain a "complete discussion of any material tax issues for which there is a reasonable possibility of challenge by the [IRS] Commissioner."
The issuers and lawyers had said the anti-abuse standard was too broad and the certificate requirement was unworkable.
The new rules revert back to the existing standard, under which bonds are taxable arbitrage bonds if they enable the issuer to exploit the difference between tax-exempt and taxable interest rates and overburden the market.
The new rules, however, also contain examples of abusive transactions that would be taxable. These include: asset sales: gray and black boxes (called "mortgage sales" in the rules); yield-blending techniques designed to avoid negative arbitrage or losses in advance refundings, window refundings, and re-refundings, commonly called Pac-Man deals.
The anti-abuse provisions also clarify that, in determining whether a transaction violates tax laws, the IRS commissioner can go beyond a deal's form to examine its "economic substance," or impact.
Some lawyers who praised the overall rules were still concerned about a few provisions.
Buck was troubled by replacement proceeds provisions that appear to broadly determine when non-bond funds are considered to be replacing bond proceeds and are, therefore, subject to yield restriction or rebate requirements.
Several lawyers also were concerned about more stringent rules governing the sizing of cash-flow financings.
Caprera was concerned that the rules create uncertainty about when swap agreements will be treated as qualified hedges so the net swap payments can be taken into account in determining bond yield for arbitrage purposes.