WASHINGTON -- The Internal Revenue Service yesterday unveiled some long-awaited technical corrections to arbitrage-related rules that were issued in final form last May.
The most significant of the more than 40 corrections were made to three rules affecting purchases of open-market Treasuries, so-called window refundings, and refundings of multipurpose issues, agency officials said. All three rules had drawn complaints from industry officials when they were issued.
The IRS modified the rule that had required issuers investing in Treasuries and certain other government securities to use the mean between the bid and the ask price to determine their investment yield for purposes of complying with arbitrage rebate or yield restriction requirements.
Industry officials had complained that the rule was unworkable and unfair because the mean price of a Treasury bond is difficult to determine and is almost never equivalent to the issuer's actual purchase price.
In modifying the rule, the IRS said issuers now may use the purchase price of these securities to determine their investment yield as long as two conditions are met. One is that the securities are purchased "in a bona fide arm's-length transaction." The other is that the purchase price does not reflect any amounts paid to reduce the investment yield.
However, issuers who already purchased these securities and who must now value them to meet rebate requirements will still have to use the mean between the bid and the ask price, according to the rule.
The IRS also clarified its "after-arising replacement amounts" rule that is aimed at stopping window refundings such as the one done for the Camden County, N.J., Municipal Utilities Authority in 1989. That deal was structured so that a window was created in which debt service payments were not due for a certain period, freeing up some of the county's sewer revenues that had been targeted for debt service. The proceeds were then invested at a yield above the bond yield to earn arbitrage and used to pay principal of the refunded issue to avoid transferred proceeds restrictions.
The IRS had issued a rule to stop such deals last May. The rule said that funds that were reasonably expected to become available to acquire investments that might have a higher yield than the bond yield would be considered to be after-arising replacement amounts that would have to be yield-restricted.
But bond lawyers had complained that the rule was overly broad in that it could prevent issuers from restructuring their debt and extending their debt service payments. They also were worried that the rule would not prevent market participants from structuring such deals to avoid transferred proceeds penalties.
In its clarification, the IRS addressed both concerns by saying that if funds that are freed up from an advance refunding are not expected to be invested for longer than six months and are not used to pay debt service on another bond issue, they will not be treated as after-arising replacements amounts that would have be to yield-restricted or that could trigger a transfer of proceeds.
The IRS' third major correction broadened the rule that allows issuers to treat multipurpose issues, in which there are new-money and refunding bonds, as separate issues. The idea behind the original rule was to allow the new-money portion of such issues to be refunded again under a 1986 law that prohibits post-1985 governmental and 501 (c)(3) bonds from being advance refunded more than once. Another intent was to allow issuers to avoid transferred proceeds penalties for the new-money portion of multipurpose issues.
But the IRS had limited issuers to going back only one generation of bonds in applying the multipurpose issue rule when those bonds had been previously refunded.
In its clarification, the IRS said issuers could go back more than one generation to apply the multipurpose rule under the refunding limit, but not to apply it to alter transferred proceeds consequences.
In another modification, the IRS clarified that it did not mean to exempt "extraordinary nonperiodic legal judgments" from working capital restrictions. The May rules had said that issuers could not issue tax-exempt bonds to finance working capital expenditures unless there were no other funds available to pay for them. The preamble to the rules suggested that certain legal judgments against an issuer would be exempted from this restriction. The rules themselves, however, did not contain an exemption and the IRS said that none was intended.