WASHINGTON -- Bond lawyers predict that some state and local issuers will push short-term, cash-flow bond financings to market before stricter arbitrage rules take effect on Aug. 15.

"The new rules will significantly affect the sizing of larger note issues," said a bond lawyer in a western state who did not want to be identified. "I think some issuers will try to get those done by Aug. 15."

He said most issuers usually borrow for cash-flow needs in the summer when their new fiscal year begins, and that the new arbitrage rules will give them a reason to do so before Aug. 15.

Several lawyers said that while they have not seen a rush to market for these deals, they expect an increased number to be done by Aug. 15.

Their comments came after The Bond Buyer reported last Wednesday that a record $11 billion of short-term notes were sold last month, most of them during the second half of the month after the arbitrage rules were published. It is unclear, however, whether the increased volume was the result of the new rules.

The rules generally took effect for bonds issued after June 30, but they can be delayed to apply to bonds issued after Aug. 15 if issuers choose to use existing rules until then.

The rules contain two new restrictions for cash-flow borrowings. One would reduce the size of the "working capital reserves" that issuers can treat as unavailable in determining the size of their deficits and cash-flow needs.

Issuers generally want to be able to treat some of their funds as unavailable because, under spending rules adopted by the IRS in 1992, the proceeds of a cash-flow financing are not considered spent if an issuer has other funds available to cover the deficit. Once the proceeds are spent, they are no longer subject to arbitrage rebate and yield restriction requirements.

Spending rules issued by the IRS in 1992 allow issuers to have working capital reserves equal to 10% of their prior year's working capital expenditures. The new rules, however, limit the size of such reserves to 5% of the prior year's expenditures, including some capital expenditures.

IRS officials said they allowed issuers to factor some capital expenditures into the 5% calculation as a simplification measure, but that the reduction to 5% from 10% should still result in smaller reserves.

The second, and even more significant, restriction is a provision that prevents issuers from financing their working capital reserves with tax-exempt notes unless they can meet a safe harbor exemption from rebate that was enacted into the tax law in 1986.

The provision says that if working capital reserves are financed with tax-exempt notes that do not meet the safe harbor exemption, the reserve funds will be treated as replacing the note proceeds and will therefore be subject to yield restriction or rebate requirements.

The new, more restrictive arbitrage rules on cash-flow financings were designed to stop issuers from using the 1992 spending rules and 1979 sizing rules to get more favorable tax treatment than was provided by the safe harbor provision in the Tax Reform Act of 1986, federal officials said.

The safe harbor provision exempts issuers doing short-term, cash-flow financings from rebate if, within six months of issuance, they have a deficit that is at least 90% of the size of their note issue.

Although it is not a tax law requirement, many issuers used the safe harbor to size their cash-flow borrowings to avoid rebate because until 1992 there were no IRS rules governing when the proceeds of cash-flow note issues were spent and no longer subject to rebate.

"If you could never deem money in your general fund to be spent, then you might be subject to rebate until your notes or bonds were retired," said a lawyer on the East Coast who also did not want to be identified.

The IRS expected the 1992 spending rules to give issuers another means of complying with arbitrage rules. Those rules said cash-flow bond proceeds would not be treated as spent if other funds were available, but issuers could maintain working capital reserves that would be unavailable.

But bond lawyers discovered that the 1992 spending rules, used in conjunction with the 1979 sizing rules, would permit state and local issuers to do larger cash-flow note issues than could be issued under the tax law's 90% safe harbor provision.

As an example, they cited a hypothetical case in which a city issued $1 1 0 million of tax and revenue anticipation notes in July based on its projections, under the 1979 sizing rules, that it would have a deficit of $1 10 million in December.

But in December, the city's actual deficit was only $91 million. The deficit occurred because the issuer had $291 million of expenditures and $200 million in revenues.

The city would not qualify for the tax law's safe harbor from rebate because its deficit was less than 90% of the size of its note issue.

But bond lawyers said the city could qualify for an exemption to rebate under the tax law's six-month spending exception. Under the May 1992 rules, an issuer was allowed to have a working capital reserve of $20 million, based on its previous year's working capital expenditures of $200 million.

That meant the issuer could treat $20 million of its $200 million of revenues as unavailable, the lawyers said. As a result, the issuer would have only $180 million of revenues, $291 million of expenses, and a deficit of $1 1 1 million. The issuer could treat the proceeds of the notes as spent to cover the deficit within six months of issuance. Under the tax laws, issuers who spend bond proceeds in six months are exempt from rebate.

"You could use the old sizing rule with the new expenditure rule to get a result in which you were more easily free from rebate than under the 90% safe harbor, " said the East Coast lawyer. "You could treat your money as spent within six months to qualify for the six-month spending exception without using the 90% safe harbor."

The new arbitrage rules are aimed at ensuring that cash-flow financings are more in line with the tax law's safe harbor by reducing the size of working capital reserves and prohibiting those reserves from being tax-exempt financed, the federal officials said.

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