One of the most frequently asked questions we receive as bond lawyers is, “How long do I have to spend tax-exempt bond proceeds?”
The easiest answer (and what the IRS would prefer) is “as soon as possible.” Ultimately, the answer is complex and can vary, but understanding the spend-down rules is extremely important in order to comply with federal tax requirements. This guidance explains how long public issuers have to spend tax-exempt bond proceeds by reviewing the concept of arbitrage and related concepts such as hedge bonds.
Arbitrage is earned when public issuers borrow funds in the tax-exempt market (through a bond issue) and invest those bond proceeds at an interest rate materially higher than the bond yield. Bonds which are issued for the purpose of earning arbitrage are referred to as “arbitrage bonds” and cannot be tax-exempt. The federal government has also implemented a regulatory framework to prevent borrowers from inadvertently issuing arbitrage bonds and therefore, earning a profit from the issuance of tax-exempt bonds. The framework focuses on preventing borrowers from issuing more bonds than are necessary for eligible project expenses and before the time funds are needed. Failing to comply with these rules may cause negative tax consequences for the issuer, including the repayment of arbitrage earnings to the IRS (rebate) or, in the worst case, the loss of tax-exempt status of a bond issue.
There are two sets of arbitrage rules issuers must follow:
1. the yield restriction rules under IRC Section 148(a); and
2. the rebate rules under IRC Section 148(f).
Yield Restriction Rules
Bonds may be arbitrage bonds if, at the time of issuance of the bond, the issuer reasonably expects to invest proceeds of the bond with a return materially higher than the bond yield. Generally, a “materially higher” return means a yield more than 0.125 percent above the bond yield.
There are three exceptions, however, which allow issuers to invest bond proceeds at an unrestricted yield: the temporary period exception, the reserve or replacement fund exception, and the minor portion exception.
1. Temporary Period Exception
The temporary period exception allows an issuer to invest bond proceeds issued for a capital project for a temporary period of three years at an unrestricted yield. In order to qualify for this exception, the issuer must reasonably expect to satisfy three tests: the expenditure test, the time test, and the due diligence test.
a. The Expenditure Test
The expenditure test is met if at least 85% of the sale proceeds of the issue are allocated to expenditures on the capital project by the end of the 3-year temporary period (from the date of issuance of the bonds).
b. The Time Test
The time test is met if the issuer incurs a substantial binding obligation to a third party to expend at least 5% of the sale proceeds on the capital project within 6 months after the date of issuance of the bonds.
c. The Due Diligence Test
The due diligence test is met if the completion of the project and allocation of sale proceeds to expenditures proceed with due diligence.
Failing the temporary period exception does not mean the bonds will automatically become taxable. Rather, the issuer may need to more actively monitor and manage the investment yield, including careful investment of funds to ensure arbitrage is not earned, or make yield restriction payments to the IRS to reduce the yield on a certain investment.
2. Reserve or Replacement Fund Exception
The reserve or replacement fund exception allows issuers to invest their bond proceeds at an unrestricted yield if proceeds are held in a “reasonably required reserve or replacement fund.” Generally, a fund is a “reasonably required reserve or replacement fund” if it does not exceed the least of:
- 10 percent of the stated principal amount of the issue;
- Maximum annual debt service on the issue; or
- 125 percent of the average annual debt service on the issue.
3. Minor Portion Exception
This minor portion exception allows an issuer to invest a “minor portion” of its bond proceeds at an unrestricted yield without having to be concerned the bonds will become arbitrage bonds. A minor portion is defined generally as the lesser of $100,000 or 5 percent of bond proceeds.
While the yield restriction rules described above detail whether the issuer can earn arbitrage at all, the next set of rules determine whether the issuer may keep these excess earnings. In other words, if one of the exceptions above applies, such as during a 3-year temporary period for a capital project, the issuer may be able to invest bond proceeds higher than the bond yield, but may still need to rebate those arbitrage earnings to the IRS. Unless an exception applies, the issuer is typically required to rebate its arbitrage to the federal government by making payments to the federal government using form 8038-T.
There are two types of exceptions to the rebate requirement: the small issuer exception and the spending exceptions.
1. The Small Issuer Exception
The small issuer exception allows an issuer to not have to rebate its arbitrage to the federal government if the issuer does not reasonably expect to issue more than $5 million of bonds in a calendar year (increased to $15 million for public school construction issues). In certain cases, current refunding bonds are not taken into account when applying the $5 million size limitation, but see the regulations for further details.
2. The Spending Exceptions
The spending exceptions provide spend-down requirements an issuer must meet in order not to have to rebate arbitrage amounts to the federal government. The federal regulations provide for three spending exceptions: the 6-month exception, the 18-month exception, and the 2-year construction exception. The spend-down requirements set forth below are based on actual facts and not reasonable expectations.
a. 6-Month Exception
The 6-month exception allows an issuer to qualify for the rebate exception if the issuer spends 100% of the gross proceeds of the issue within 6 months of issuance.
b. 18-Month Exception
The 18-month exception allows an issuer to qualify for the rebate exception if the issuer meets the following spend-down schedule:
- At least 15% of gross proceeds spent within 6 months
- At least 60% of gross proceeds spent within 12 months
- 100% of gross proceeds spent within 18 months
c. Two-Year Construction Exception
In the case of a construction issue where an issuer reasonably expects at least 75% of the available construction proceeds of a construction issue will be used for construction expenditures, an issuer qualifies for the two-year construction rebate exception if the issuer meets the following spend-down schedule:
- 10% of the construction proceeds (issue price plus earnings, minus proceeds deposited in a reasonably required reserve fund and proceeds used to finance issuance costs) spent within 6 months beginning on the bond issuance date;
- 45% of such proceeds spent within 1 year;
- 75% of such proceeds spent within 18 months; and
- 100% of such proceeds spent within 2 years.
Unrelated to the concept of arbitrage, but directly related to the concept of when bond proceeds must be spent is the concept of “hedge bonds.” IRC section 149(g) is meant to prevent issuers from issuing bonds when interest rates are low even though there is not an immediate or planned need for the funds. The IRS is interested in preventing issuers from “hedging” against the risk that interest rates will rise, and therefore issuing more bonds than necessary (overburdening the tax-exempt bond market).
One section of the tax rules pertaining to hedge bonds provides that to avoid a bond becoming a hedge bond, an issuer must reasonably expect 85% of the spendable proceeds of the issue will be used to carry out the governmental purposes of the issue within the 3-year period beginning on the date the bonds are issued. If bond proceeds are not reasonably expected to be spent within this time frame, different tax rules are implicated, and it is highly advised to discuss the expected spend-down of bond proceeds with bond counsel to ensure the bonds are not taxable hedge bonds.
In the current low interest rate environment, the IRS is particularly focused on reviewing spend-down requirements to ensure issuers utilize bond proceeds within the rules described above. Issuers should review the requirements for when bond proceeds must be spent with bond counsel to avoid negative tax consequences.
This guidance is intended to provide a high-level explanation of a complex area of federal tax law. For a detailed understanding of your particular set of facts, we strongly recommend you consult with your bond counsel.