WASHINGTON - The Internal Revenue Service yesterday proposed a drastic overhaul and simplification of its current arbitrage rules that would give bond issuers an unexpected new safe harbor from rebate requirements.

The 178-page set of proposed rules, FI-36-92, the text of which is about one-third the size of the existing regulations, is now available at the IRS and will be published in the Federal Register tomorrow.

An IRS official stressed in an interview that the rules, which have been rewritten and consolidated, are only proposed and would not be issued in final form until next year. The final rules would not take effect until after June 30, 1993, the date the existing arbitrage regulations are due to expire.

"Our intent was to get these rules out for a reasonable public comment period, a public hearing, and time to make revisions so that we could go final on them by next June," said John J. Cross 3rd, IRS counsel to the assistant chief counsel for financial institutions and products and one of the principal authors of the rules.

The deadline for public comments is Jan. 15, 1993.

The proposed rules, which were also written by Mitchell Rapaport, the Treasury's attorney-adviser for tax-exempt bonds, would provide most municipal bond issuers with a new 18-month spending exception from rebate requirements. Issuers would be exempt from rebate if they spent 30% of their bond proceeds in six months, another 30% in one year, and the remaining 40% in 18 months.

The new spending exception would be an alternative to the current six-month spending exception, which most issuers complain is too short, and to the two-year spending exception, which many bond market participants have complained is too complex and unworkable because of the tax laws that established it. The 18-month spending exception is broader than the two year rule because it applies to most issuers and financings rather than to just issuers of governmental and 501(c)(3) bonds that finance construction.

Cross said the IRS has the authority to propose the new spending exception because Congress authorized it in 1986 to develop safe harbors providing issuers with some exemptions to the rebate requirements. At the same time, the rules would simplify the mechanics of the two-year rule.

The rules also would make it easier for issuers to comply with rebate requirements when they could not qualify for an exemption from them. The rules would allow issuers of fixed-rate bonds, for example, to determine their bond yield for arbitrage purposes at the time of issuance, taking into account reasonably expected redemptions. Under the existing rules, issuers may have to recalculate their bond yields when bonds are called or redeemed early.

The proposed rules would ease restrictions on the eligibility of credit enhancement providers. They would also ease the extent to which fees for credit enhancement can be treated as interest on bonds that would increase the issuer's bond yield for arbitrage purposes.

The rules would simplify the requirements for the valuation of bonds or investments for plain-vanilla deals. Issuers that needed to value their bonds every five years for rebate computations, for example, could use the outstanding principal amount of the bonds as long as they were not issued at a premium or discount.

The rules would ease yield restriction requirements and help integrate them with rebate requirements by allowing certain issuers to make payments to the IRS or the Treasury to reduce their bond yield in lieu of yield-restricting their investments. This rule would apply for specific financings in which yield restriction is difficult, such as variable-rate bonds and student loan bonds.

In its rewrite of the arbitrage rules, the IRS also eliminated or significantly modified some of the rules it had recently issued that bond market participants had complained were too confusing or too tough.

For example, the reimbursement rules issued in final form late last year would be shortened to about six pages from more than 20 and would be significantly simplified. They also would be expanded to apply to all issuers, not just issuers of governmental and 501 (c)(3) bonds.

An issuer would have up to 60 days after making an expenditure to issue a resolution of official intent to issue bonds to reimburse itself for the expenditure. The issuer would have to reimburse itself within 18 months of when the expenditure was paid or the project was placed in service, whichever was later. The reimbursement could not be made later than three years after the project was placed in service.

Small issuers and small reimbursements would be provided with relief from these general rules.

The proposed rules also would change refunding rules that were made final only six months ago. The new rules, for example, would completely drop an after-arising replacement amounts rule that had been aimed at halting so-called window refundings but that had caused confusion among bond lawyers. Window refundings would be restricted, instead, under broad anti-abuse rules.

The proposed rules would eliminate many of the detailed provisions of the existing rules that were aimed at halting specific abuses in the overall bond market, and would instead replace these provisions with broad anti-abuse rules.

One of the anti-abuse rules - a broader version of the existing artifice and device rule - would treat as taxable some of the advance refundings that involve yield-blending, which are currently being done to save issuers' refundings from negative arbitrage in today's market.

While these are proposed rules, the IRS "is actively considering published guidance under the existing artifice and device rule" that could retroactively stop such transactions, an IRS official said.

Another proposed anti-abuse rule in the package would severely restrict so-called asset sales transactions, in which the underlying loan obligations of tax-exempt bond issues are sold as tax-exempt obligations.

The proposed arbitrage rules cover certain hedging transactions such as interest rate swap transactions. The rules would allow issuers involved in swap transactions, in which the swap agreement closely matched the underlying bonds, to take into account the net payments on the swap in determining their bond yield for arbitrage purposes.

The rules would allow issuers to recover overpayments of arbitrage before the bonds matured, as long as the issuer could demonstrate that it deserved the refund. The existing rules say issuers cannot get refunds until after the bonds are paid.

The rules propose a new definition of "issue" for arbitrage purposes, in the hope that it will lead to an overall definition of issue that can be used for all bond regulations, Cross said.

Under the new definition, two or more obligations would be treated as part of the same bond issue if they were: * Sold or issued at substantially the same time, meaning within 15 days. * Sold pursuant to the same plan of financing. * Payable from the same source of funds without regard to credit enhancement.

Taxable and tax-exempt issues generally would be treated as separate issues under the definition, Cross said.

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