WASHINGTON -- The Internal Revenue Service yesterday unveiled a series of corrections and clarifications to provisions of the arbitrage rules that affect student loan bonds, reimbursements, refundings, single family housing bonds, and interest rate swaps.

The 31 so-called technical corrections, which are effective immediately and may be applied retroactively, range from fixing typographical errors to clarifying the substance of certain provisions of the rules issued last June.

"Most of these are taxpayer favorable," said John J. Cross, 3rd, the IRS' counsel to the assistant chief counsel for financial institutions and products.

One exception, however, is the correction of an inadvertent glitch that would have allowed some issuers who refund student loan bonds issued before Jan. 6, 1990, to have more favorable arbitrage treatment than intended.

But Cross said the municipal market should have expected the student loan bond correction.

"It should have been inappropriate for anyone to use the construction of the rule" as it was first published, he said.

The rule had allowed issuers doing such refundings to earn a 2% spread between the yields of their bonds and the underlying student loans without taking "special allowance payments" into account in arbitrage calculations.

The Department of Education makes these payments to help issuers cover the costs of administering and servicing the loans. When included in arbitrage calculations, the payments are treated as additional interest and would make it tougher for the issuer to keep its investments within the permitted yield.

The corrected rule says that if such issuers do not include the special allowance payments in their arbitrage calculations, they can only earn a 1.5% spread.

The IRS also made an unexpected clarification to the arbitrage rules' hedging provisions on interest rate swaps that will help issuers using such swaps in advance refundings.

Under the hedging rules, certain floating-rate to fixed-rate interest swaps are treated as fixed-rate bond issues. But the rules say that if the swap is terminated within five years of issuance, the bonds are to be treated as variable-rate. The yields of variable-rate bonds must be determined in five year snapshots. For issues with serial and term bonds, the first five-year snapshot yield would be low, forcing issuers doing refunding to use that low yield to determine the yield of its escrow, which must be yield-restricted to the bond yield.

The IRS eliminated this problem, however, by clarifying that the rule on terminations of swaps within five years applies only for rebate purposes and not for yield restriction.

The IRS is considering issuing further guidance on the hedging provisions at a later date, Cross said. The agency has received several recommendations from industry groups and firms for other changes in the hedging rules and is currently studying them, he said. But no decisions have been made, he said.

In another correction favorable to the bond industry, the IRS said issuers could go back more than one generation of multi-purpose bond issue to determine the number of times bonds can be refunded under tax law restrictions.

Bond issues are multi-purpose if they include both refunding and new-money bonds, or if they finance several projects. Under the tax law, governmental and 501 (c)(3) bonds can only be advance-refunded once if they were originally issued after Dec. 31, 1985, and twice if issued on or before that date.

The IRS also corrected a rule that had said reimbursement bonds in some cases could not be issued on a tax-exempt basis if a project was already placed in service. The glitch, which most bond lawyers had recognized was a mistake, occurred when the IRS was trying to integrate prior rules dealing with private activity bond reimbursements with newer reimbursement rules for governmental and 501(c)(3) bonds, Cross said.

Another clarification deals with "replacement" rules that are intended prevent issuers from using tax-exempt bonds to finance a project that could have been paid for with other funds that are being invested for profit.

The rules set forth the conditions under which the funds that an issuer or borrower has onhand will be treated as replacing bond proceeds and will become subject to same yield restriction or rebate requirements.

The rules also say that an issuer may be deemed to have "replacement proceeds" if its bonds remain outstanding longer than necessary. But the rules contain three safe harbors under which bond issues with certain maturities will not be deemed outstanding longer than necessary.

The IRS clarified that the safe harbor that applies to new-money capital financings also applies to refundings. The safe harbor says a capital financing will not be deemed outstanding longer than necessary if its weighted average maturity does not exceed 120% of the "average reasonably expected economic life" of the project being financed.

Another significant clarification was made to arbitrage rules on single family housing bonds. The arbitrage rules give issuers of single family housing bonds a three year "temporary period," during which yield restriction requirements do not apply. The IRS clarification says issuers also get the three-year temporary period when recycling bond proceeds to make new loans.

The IRS corrected the so-called "mixed escrow rule," which tells issuers refunding bonds how to structure escrows that contain equity, proceeds of the bonds being refunded, and/or proceeds of the refunding bonds.

The rule, as published in June, had said that if money in a bona fide debt service fund was put into a mixed escrow, it would have to be used for the "earliest expenditures from the mixed escrow." But bond lawyers complained that the rule was difficult to apply in practice. So the IRS said in the correction that the money should be invested in "the earliest maturing investments in the mixed escrow."

A bona fide debt service fund typically contains enough money to pay debt service for a year and must be emptied annually.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.