The 2013 proposed arbitrage regulations included significant changes to the working capital financing rules, including the first rules for long-term working capital financings. The proposed rules have been finalized in the recently issued final arbitrage regulations (discussed here) (“Final Regulations”), with some changes but without one very significant suggested change. This post summarizes the important changes that were made to the proposed working capital regulations (“Proposed Regulations”) and commiserates with our readers over the significant change that Treasury rejected.

Non-“Restricted” Working Capital Financings

Let’s start on a positive note with the beneficial changes to the Proposed Regulations. Prior to the Final Regulations, issuers got a 13-month temporary period for financings of “restricted working capital expenditures,” defined as working capital expenditures subject to the proceeds-spent-last rule, as long as the issuer expected to spend the proceeds (applying the proceeds-spent-last rule) within that 13-month period. These financings also qualified for a two-year or 13-month maturity (depending on your interpretation) safe harbor from the creation of “other replacement proceeds” resulting from leaving bonds outstanding longer than necessary.

The narrow temporary period rule left practitioners wondering what if any temporary period (other than the blanket 30-day temporary period) applied to financings of working capital that qualified for an exception from the proceeds-spent-last rule. An example is the financing of a casualty loss or an extraordinary legal judgment. In response to a comment to the Proposed Regulations, Treasury extended the 13-month temporary period to all working capital financings (merely by deleting the word “restricted”), again provided the proceeds are expected to be spent within that 13-month period.

For the safe harbor-maturity rule – formerly 13 months or two years, as expected Treasury clarified that the limit is 13 months. On a positive note, Treasury extended this rule to all (not just restricted) working capital financings. While this is helpful, in my experience when a financing of an extraordinary working capital expenditure is required, the issuer usually needs that financing in place significantly longer than 13 months. If a longer financing is issued for that purpose, the Final Regulations provide just two potential sources of support. First, as was included in the Proposed Regulations, the Final Regulations add as a factor that may justify a bond maturity longer than the 13-month safe harbor an issuer’s need to finance extraordinary working capital expenditures. Second, an issuer can apply the long-term working capital rules (discussed below) to an extraordinary working capital financing.

Long-Term Working Capital Financing

Other than through letter rulings, the Proposed Regulations provided the first glimpse into Treasury’s and the IRS’s thinking on long-term working capital financings. The approach taken was fairly reasonable, generally requiring that, after a period no longer than five years during which the issuer expected no “available amounts,” the issuer was required to use any available amounts actually arising either to pay down bonds or to invest in “non-alternative minimum tax” tax-exempt investments (“Non-AMT Investments”), the theory of the latter alternative being that investment in Non-AMT Investments by a governmental entity is equally valuable to Treasury in reducing the amount of tax loss.

One unfortunate technicality in the Proposed Regulations was that available amounts must be measured on the first day of the issuer’s fiscal year. This approach to available amounts would result in a virtually random measure of available amounts, depending on whether that just happened to be a day on which the issuer was flush with cash or scraping by and anxiously awaiting its next tax receipts. If the issuer happened to have a lot of cash that day and if it used the cash to pay down bonds, it may well need to return to the market a short time later to cover its next deficit. Commenters pointed this out to Treasury and sought greater flexibility but Treasury rejected the comments. The Final Regulations have retained the first day of the issuer’s fiscal year as the required measurement date of available amounts.

Treasury explained its position in the preamble to the Final Regulations on the basis of “administrability and consistency.” Treasury found the commenters suggestions too complex, and thus not administrable, while not necessarily leading to a more appropriate result. Treasury also noted the consistency between this rule and the rules governing the identification of “other replacement proceeds” when bonds are left outstanding too long, which also requires measurement on the first day of the issuer’s fiscal year. Of course, the latter rule has gotten little attention because it almost never applies, but merely acts as a warning to issuers not to issue bonds with a maturity longer than necessary. Thus the significance of consistency in these rules is overstated.

As a practical matter, the requirement of measuring available amounts on the first day of the fiscal year will push issuers in many or most cases to invest available amounts in Non-AMT Investments. This allows the issuer to keep the funds available to cover subsequent shortfalls and, at least to that extent, to avoid issuing more debt. In this regard it is worth noting that the Final Regulations clarify that an issuer may sell Non-AMT Investments in order to spend the money, provided it then has no other available amounts. A further helpful clarification in the Final Regulations facilitating investment in Non-AMT Investments is that Demand Deposit SLGS will qualify for this investment. While this certainly appeared to be the case prior to the clarification, it may be helpful to have the explicit rule in case of an audit.

Finally, one last beneficial change (for both long-term and short-term working capital financings) from the Proposed Regulations to the Final Regulations is the change in the definition of available amounts. Previously, the definition excluded proceeds of “the” issue from available amounts but did not exclude proceeds of other issues. The Proposed Regulations did not address this point but the Final Regulations change “the” to “any.” Under the prior rule, for example, an issuer with multiple working capital issues outstanding might have been required to invest the proceeds of one issue in Non-AMT Investments (or use the amounts to redeem bonds) in order for the other issue to satisfy the investment/redemption requirement. This could have defeated the purpose of, or at least placed an unfair burden on, the working capital financings so Treasury eliminated this result by revising the exclusion from available amounts from “proceeds of the issue” to “proceeds of any issue.”