WASHINGTON - State and local issuers that apply the new arbitrage rules retroactively to previously issued bonds may be able to obtain a refund of some of the arbitrage they rebated to the federal government, an Internal Revenue Service official said yesterday.
You can apply for a refund "if the consequences of electing into the new regulations would entitle you to a refund of a rebate payment previously made," John J. Cross 3rd, counsel to the assistant chief counsel for the IRS' financial institutions and products division, said at a Government Finance Officers Association seminar on the rules.
Cross said this was one of the most difficult issues with which IRS officials had to wrestle in determining whether to allow the rules to be retroactively applied.
Ultimately, agency officials decided to allow issuers to apply the new rules to all of their tax-exempt bond issues "so that everyone will be singing from the same songbook," he said.
Cross cautioned, however, that some of the new rules cannot be applied retroactively. State and local issuers, for example, will not be able to retroactively apply a new 18-month spending exception to rebate requirements that the new rules provide for the first time, he said. Under this exception, issuers are exempt from rebate if they spend 15% of their bond proceeds in six months, 60% in 12 months, and 100% in 18 months.
In addition, states and localities that issued bonds under the two-year rebate relief law and opted to pay a penalty rather than be subject to rebate if they failed to meet the spending targets cannot use the new rules to escape from penalty payments, Cross said. Under the two-year rebate relief law, issuers are exempt from rebate if they spend 10% of their proceeds in six months, 45% in 12 months, 75% in 18 months, and 100% in 24 months. At the time of issuance, they must choose whether to pay a penalty equal to 1.5% of unspent proceeds or rebate arbitrage if they fail to meet these targets.
Cross said the new rules need technical clarifications and corrections, but he was unable to shed much light on their scope or when they would be forthcoming.
"We hope to provide these technical changes as close as possible to the Aug. 15 final effective date to provide for an orderly transition. But we're not in any position to comment on either the form or content, or timing of these changes," he said.
Cross noted that a correction must be made to the rules governing student loan bonds, for example, to make clear that issuers refunding certain student loan bonds do not get more favorable arbitrage treatment than intended.
Another correction must be made to rules governing reimbursement bonds that wrongly suggest such bonds cannot be issued on a tax-exempt basis, in some cases, if a project has already been "placed in service." he said.
Cross said IRS officials are "somewhat sympathetic" to industry concerns that "plain vanilla inverse floater bonds" should be treated as fixed-rate bonds, which would make arbitrage compliance much easier for issuers of these bonds.
In inverse floater transactions, two sets of bonds are issued. One bears a floating interest rate based on an index. The other bears interest at a certain percentage rate minus the index and floats inversely to the market.
"Technically under our rules, that doesn't fit within the fixed yield definition." he said. "It's perfectly self-hedged, however, and so it's consistent with our policy with letting people determine their yield up front and not having to look back.
"Having said that, I must add that it goes downhill from there with regard to other kinds of hedging products that people are asking us to do more with. "
Cross indicated that if the IRS does clarify that plain vanilla inverse floater bonds will be treated as fixed-rate securities, it will be through revenue rulings or revenue procedures rather than through changes in the arbitrage rules. He noted that the arbitrage rules give the IRS commissioner the flexibility to offer special treatment to certain hedging transactions through revenue rulings or revenue procedures.