WASHINGTON - The arbitrage rules should be simplified to allow issuers to comply with rebate rather than yield restriction requirements for most bond issues, a bond lawyers' group has told the Internal Revenue Service.
The National Association of Bond Lawyers made the request in a 49-page comment letter on the rules. The IRS is expected to propose rewritten rules soon.
The agency has been working for months to consolidate several sets of arbitrage rules that it issued during the past three decades to make them simpler and more workable.
The bond lawyers' group told the IRS that the rules would be greatly simplified if issuers were allowed to meet rebate rather than yield restriction requirements in most cases, with some possible exceptions such as advance refunding escrows or invested sinking funds.
The problem with yield restriction requirements, several lawyers said in interviews, is that they require issuers to continuously monitor their invested bond proceeds to make sure their investment yield is below their bond yield.
When short-term rates fall way below long-term rates, as is the case in the current market, they said, the issuer cannot get an investment yield that even approaches its bond yield and is stuck with negative arbitrage or a loss.
If an issuer of fixed-rate bonds is allowed to comply with rebate requirements, it can invest its bond proceeds freely and then rebate the arbitrage, if any results, once every five years.
In the comment letter, the association told the IRS that "two guiding principles should be paramount" in rewriting the rules.
First, it said, the rules should apply consistently for both yield restriction and rebate purposes to the greatest extent possible.
The yield restriction requirements, which went into effect in the 1970s, were based on reasonable expectations. An issuer financing a project typically would be given three years during which it could earn and keep arbitrage profits as long as it reasonably expected to spend 85% of the bond proceeds on the project during that period.
In contrast, the rebate requirements, which went into effect in the mid-1980s, are based on the actual difference between the issuer's investment yield and bond yield over a certain period of time.
A second principle, the association said, is that the rules "should be aimed at achieving rough justice rather than taking the ~last cent' of arbitrage approach that characterized certain past regulatory efforts."
The association also made recommendations on several specific aspects of the rules, ranging from basic definitions to complex refunding concepts.
The group said, for example, that while "sales proceeds" is a "fundamental starting point" for many of the arbitrage rules, "we still do not have a clear, simple and, concise meaning of the term." Lawyers have questions about the definition of sales proceeds, such as whether the term includes the underwriter's discount that is withheld from the price of the issue, they said.
The comment letter praised the arbitrage rules' universal cap concept as a very sound idea" but said it has led to confusion and should be simplified.
Under the universal cap concept, an issuer cannot have more bond proceeds than it has bonds outstanding. But this has resulted in confusion over how proceeds should be allocated among bond issues, particularly in refundings, when the cap has been exceeded. To eliminate confusion, the letter says, the IRS should preclude the need for reallocation of proceeds when the cap has been exceeded.
The lawyers also said the rewritten rules should clarify that "administrative costs" include only the "costs paid by or on behalf of an issuer" for brokerage commissions. legal and accounting fees, and other expenses. Such costs are treated as the costs of acquiring investments and can lower the issuer's investment yield for arbitrage purposes.
The rewritten rules also should be modified to make clear that an investment contract provider's refusal to bid should be counted effectively as a bid, according to the lawyers' group. This would allow the issuer to meet the three-bid requirement for determining the fair market value of investment contracts and certificates of deposit, the lawyers said.
If an investment contract is purchased at its fair market value, then the cost of acquiring it can be taken into account in determining the investment yield.
The comment letter also urged the IRS to reconcile the long-standing rules on tax and revenue anticipation note financings with newer rules on working capital, which are inconsistent in some cases. The group suggested the reconcillation in part because the two sets of rules contain different safe harbors for issuers who want to make sure their financings are exempt from rebate requirements.
The older rules say a Tran issue is exempt from rebate if the actual deficit of the issuer was 90% of the face amount of the issue within six months of the date of issuance. The newer rules say the issue is exempt if, within six months of issuance, the working capital expenditures that were financed exceeded other funds available for working capital by 100% of the bond proceeds.
The comment letter contains many recommendations on refunding rules. One calls for the rewritten rules to clarify that the fair market value of securities in a refunding escrow be determined on the date that the refunding issue is priced and the escrow securities are "locked in."
The lawyers' group also said it is troubled by the "after-arising replacement amounts" concept that was recently added to the rules to prohibit so-called window refundings. One lawyer said this concept can be interpreted so broadly that it kills most refundings or so narrowly that it does not even restrict window refundings.
Window refundings are structured so that debt service is eliminated in the early years and the freed-up revenues that were earmarked for debt service can be invested at a yield above the bond yield.
The comment letter says the rewritten rules should not treat a refunding that merely extends the maturity of the issuer's debt as an abuse that results in after arising replacement amounts - amounts that must be yield restricted or that trigger a transferred proceeds penalty.
The letter also says issuers should be allowed to go back more than one generation of multipurpose bond issues to treat issues separately to alter transferred proceeds consequences. It also recommends that the rewritten rules allow issuers that are advance-refunding bonds to pay a transferred proceeds penalty directly to the IRS instead of paying it through yield restriction requirements.
The comments were compiled by William H. Conner, a partner with the firm of Squire, Sanders & Dempsey in Cleveland.