n-10-05.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Arbitrage Treatment of Certain Guarantee Funds

Notice 2010-5

This Notice describes proposed rules that the Internal Revenue Service (IRS)
and the Department of the Treasury expect to issue regarding whether certain perpetual
trust funds created and controlled by States that are pledged as credit enhancement to
guarantee tax-exempt bonds will be treated as replacement proceeds of the guaranteed
bonds for purposes of the arbitrage investment restrictions on tax-exempt bonds under
§ 148 of the Internal Revenue Code (Code). (Unless noted, section references in this
Notice are to the Code and the Income Tax Regulations.) Such rules are intended to
provide further flexibility to State and local governments to obtain credit enhancement
for tax-exempt bonds in recognition of credit constraints in the municipal bond market.
This Notice affects certain state guarantee programs that support local public schools
and other governmental purposes.
In addition, this Notice solicits public comments regarding provisions of the
regulations under § 148 that may impede an issuer’s ability to obtain credit
enhancement for tax-exempt bonds.

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SECTION 2. BACKGROUND
In general, the interest on bonds issued by State and local governments is
excludable from gross income under § 103(a) if certain requirements are met. Section
148 imposes arbitrage investment restrictions on tax-exempt bonds that limit the
investment of proceeds of tax-exempt bonds in higher-yielding investments and that
require issuers to rebate certain excess earnings above the yield on tax-exempt bonds
to the Federal Government. The arbitrage restrictions apply to ordinary proceeds
derived from the sale of tax-exempt bonds and investment earnings thereon. In
addition, the arbitrage restrictions apply to a special type of tax-exempt bond proceeds,
known as “replacement proceeds,” as a result of their use as security for tax-exempt
bonds or other nexus to tax-exempt bonds. These special replacement proceeds
include, among other things, certain “pledged funds” that are pledged to secure
repayment of tax-exempt bonds with a reasonable assurance of availability for such
purpose. One special exception to the treatment of pledged funds as replacement
proceeds covers certain perpetual trust funds under certain parameters and under a
specified size limitation, as described further herein.
In particular, § 148(a) defines an arbitrage bond as any bond issued as part of
an issue any portion of the proceeds of which are reasonably expected (at the time of
issuance of the bond) to be used directly or indirectly (1) to acquire higher yielding
investments or (2) to replace funds which were used directly or indirectly to acquire
higher yielding investments. Section 148(a) further provides that a bond is an arbitrage
bond if an issuer intentionally uses any portion of the proceeds of the issue of which

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such bond is a part to acquire higher yielding investments or to replace funds which
were used directly or indirectly to acquire higher yielding investments. In addition,
§ 148(f) requires that issuers rebate certain excess earnings on proceeds of tax-exempt
bonds to the Federal Government. Under §§ 1.148-2(a) and 1.148-3(a) of the Income
Tax Regulations, “proceeds” for these purposes means “gross proceeds”. Section
1.148-1(b) defines “gross proceeds” to include proceeds and replacement proceeds of
an issue.
Section 1.148-1(c)(1) defines “replacement proceeds” as amounts that have a
sufficiently direct nexus to a tax-exempt bond issue or to the governmental purpose of a
tax-exempt bond issue to conclude that the amounts would have been used for that
governmental purpose if the proceeds of the bond issue were not used or to be used for
that governmental purpose. Section 1.148-1(c)(1) further provides that replacement
proceeds include, but are not limited to, sinking funds, pledged funds, and other
replacement proceeds described in § 1.148-1(c)(4) to the extent that those funds or
amounts are held by or derived from a substantial beneficiary of the issue. Section
1.148-1(c)(1) defines a substantial beneficiary of an issue to include the issuer of such
issue, any related party to the issuer and, if the issuer is not a State, the State in which
the issuer is located. Section 1.148-1(c) further provides, however, that a person is not
a substantial beneficiary of an issue solely because it is a guarantor under a qualified
guarantee.
Section 1.148-1(c)(3)(i) defines a “pledged fund” as any amount that is directly or
indirectly pledged to pay principal or interest on the issue. Although a pledge need not

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be cast in any particular form, it must, in substance provide reasonable assurance that
the amount will be available to pay principal or interest on the issue even if the issuer
encounter financial difficulties.
Section §1.148-11(d)(1) provides a special exception to the treatment of funds as
pledged funds for arbitrage purposes for certain perpetual trust funds if the
requirements and limitations enumerated in §§ 1.148-11(d)(1)(i) through (vi) are
satisfied. Specifically, § 1.148-11(d)(1) provides that a guarantee by a fund created and
controlled by a State and established pursuant to such State’s constitution does not
cause the amounts in such fund to be pledged funds treated as replacement proceeds
for purposes of § 148 if: (i) substantially all of the corpus of the fund consists of
nonfinancial assets, revenues derived from these assets, gifts, and bequests, (ii) the
fund corpus may be invaded only to support specifically designated essential
governmental functions (the “designated functions”) carried on by a political subdivision
with general taxing powers; (iii) substantially all of the available income of the fund is
required to be applied annually to support the designated functions; (iv) the issue of
bonds guaranteed consists of general obligation bonds that are not private activity
bonds substantially all of the proceeds of which are to be used for the designated
functions; (v) the fund satisfied all of requirements in §§ 1.148-11(d)(1)(i) through (iii) on
August 16, 1986; and (vi) the guarantee is not attributable to a deposit to the fund after
May 14, 1989, unless the deposit is attributable to the sale or other disposition of fund
assets or unless prior to the deposit, the outstanding amount of the bonds guaranteed
by the fund did not exceed 250 percent of the lower of the cost or fair market value of

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the fund.
The recent financial crisis has resulted in significant volatility in the fair market
value of assets in these perpetual trust funds and has constrained the availability of
credit enhancement in the municipal bond market. As a result, certain perpetual trust
funds that otherwise could provide credit enhancement under the special exception to
the arbitrage restrictions for eligible pledged funds under § 1.148-11(d)(1) have been
limited in their capacity to provide guarantees for tax-exempt bonds at a time when
there is a significant need for such guarantees.
SECTION 3. SCOPE AND APPLICATION
The IRS and the Department of the Treasury intend to issue proposed
regulations to amend § 1.148-11(d)(1)(vi) in its entirety to provide that, as of the sale
date of the tax-exempt bonds to be guaranteed, the amount of the bonds to be
guaranteed by the fund plus the then-outstanding amount of bonds previously
guaranteed by the fund may not exceed a total amount equal to 500 percent of the total
costs of the assets held by the fund as of December 16, 2009.
SECTION 4. RELIANCE ON THIS NOTICE
This Notice may be relied upon for bonds sold on or after December 16, 2009
and before the effective date of future regulations or other public administrative
guidance under § 148 addressing or otherwise affecting funds described in § 1.148-
11(d)(1) and this Notice.
SECTION 5. REQUEST FOR COMMENTS
Before any notice of proposed rulemaking is issued with respect to the guidance

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provided in this Notice, consideration will be given to any written public comments on
this Notice that are submitted. In addition, the Treasury Department and the IRS
specifically request comments regarding provisions of the regulations under § 148 that
may impede an issuer’s ability to obtain credit enhancement and how those provisions
should be amended. Comments should be submitted in writing and can be emailed to
notice.comments@irscounsel.treas.gov (include “Notice 2009-5” in the subject line) or
mailed to Office of Associate Chief Counsel (Financial Institutions and Products), Re:
Notice 2009-5, CC:FIP:B5, Room 3547, 1111 Constitution Avenue, NW, Washington,
DC 20224. Comments that are submitted will be made available to the public.
SECTION 6. DRAFTING INFORMATION
The principal authors of this Notice are Aviva M. Roth and Johanna Som de
Cerff, Office of the Chief Counsel (Financial Institutions and Products). However, other
personnel from the IRS and the Treasury Department participated in its development.
For further information regarding this Notice, contact Johanna Som de Cerff at (202)
622-3980 (not a toll-free call).