On September 26, 2007, the Internal Revenue Service released proposed rules that would modify certain provisions of the arbitrage regulations under Section 148 of the Internal Revenue Code of 1986, as amended (the “Proposed Regulations”). The Proposed Regulations focus primarily on the use of interest rate swaps in refunding transactions, but also address other issues that have arisen under the Section 148 regulations, some of which are not related to the use of hedges at all.

A lengthier, more general discussion of the provisions of the Proposed Regulations appeared in the Hunton & Williams LLP Client Alert distributed on October 1, 2007. This alert focuses on two particular practice points which should be considered as a result of the Proposed Regulations and their effective date provisions.

New Rebate Computation Credit

If adopted in their current form, the Proposed Regulations will increase the annual $1,000 rebate computation credit to $1,400 for bond years ending in 2007 or later years. An escalation clause (based on the consumer price index) applies to this number for future years. This 40 percent credit increase is a direct gain for issuers in rebate calculations. The Proposed Regulations allow all existing issues which have proceeds invested in nonpurpose investments during a qualifying bond year (e.g., a bond year ending on or after September 26, 2007) to elect to have this provision apply, regardless of whether any other part of the Proposed Regulations will apply to the issue. There is simply no reason not to do this for your calculations.

Elimination of Yield Monitoring/Sinking Fund Balancing Measure

The Proposed Regulations would permit the use of “yield reduction payments” to assure that an advance refunding escrow complies with yield restriction requirements when a variable-rate bond issue is paired with a taxable (e.g., LIBOR) market-based interest rate swap. This will considerably simplify situations using variable rate bonds for refundings. Under the current rules, many issuers have established and maintain a special sinking fund with additional investments, monitor the bond yield and, if the bond yield drops below the escrow yield, are required to intentionally invest the sinking fund without any return, in order to blend down the yield on the refunding escrow. The Proposed Regulations would permit retroactive yield compliance by payment to the US Treasury of amounts similar to rebate payments, thereby reducing this complexity to monitoring the bond yield and writing a check.

Under the effective date provisions of the Proposed Regulations, this provision may be applied to an issuer’s existing situation if the following is correct: 

  • All variable rate bonds of the issue are subject to the hedge; 
  • The hedge is a qualified hedge, covering a period at least from the issue date to the end of the escrow period;
  • The hedge has a rate payable by the provider intended to be generally equal to the bond rate; and
  • New investments are purchased for the escrow on or after September 26, 2007.

If these conditions are met, the issuer can use yield reduction payments with respect to the new investments. This should then allow the issuer to cease any detailed monitoring activities being undertaken and probably release amounts in any collateral sinking funds created to blend down yields.

Depending upon whether any changes are made in the provisions when the Proposed Regulations are finalized, it may be possible to also apply yield reduction payments to old investments in this situation.