On December 8, 2016, the Internal Revenue Service (IRS) released final regulations (the Final Regulation) on the definition of "issue price" for purposes of the arbitrage provisions applicable to tax-exempt bonds under Section 148 of the Internal Revenue Code of 1986, as amended (the Code).

Background. With respect to tax-exempt bonds issued by State or local governments, section 148 of the Code generally limits the ability to invest proceeds of the bonds at investment yields that are materially higher than the yield on the bonds, and in certain circumstances requires that amounts earned in excess of the bond yield be rebated to the federal government. For this purpose, the yield on the bonds is computed based on the “issue price” of the bonds as generally determined under the original issue discount provisions of the Code.

For many years the regulations under Section 148 generally have provided that the issue price of bonds is the first price at which a substantial amount of the bonds (defined as at least 10 percent of each maturity) were sold to the public (excluding sales to underwriters). In order to provide certainty on the sale date (i.e., the date that the issuer and the underwriter sign the bond purchase agreement) for bonds being sold in a bona fide public offering, the regulations have provided a special rule allowing the issue price of such bonds to be determined on the basis of the reasonably expected public offering price to the public as of the sale date, regardless of the prices at which the bonds were actually sold to the public.

Out of concern that the reasonable expectations standard may be subject to abuse, in 2013 the IRS issued proposed regulations which would have eliminated the reasonable expectations standard in favor of an issue price definition based on actual sale prices to the public. The 2013 proposed regulations were criticized as not providing the needed certainty as of the sale date, and were withdrawn by the IRS. In 2015, the IRS issued new proposed regulations, which again provided a reasonable expectations standard, but with certain additional requirements intended to curb the potential for abuse, and those rules have been adopted in the Final Regulations subject to certain modifications discussed below.

The Final Regulations. The Final Regulations continue the general standard that the issue price is the first price at which a substantial amount of bonds (defined as at least 10 percent of each maturity) is sold to the public, excluding sales to underwriters. In response to comments, the Final Regulations clarify that in the case of bonds sold in a private placement to a single buyer, the issue price is the price paid by that buyer.

In order to provide greater certainty on the sale date, the Final regulations provide that in the case of a public offering of bonds, the original offering price of the bonds to the public as of the sale date may be considered the issue price, but only if (i) the lead underwriter provides the issuer with a certification of the public offering price along with supporting documentation (such as a copy of the pricing wire), and (ii) each underwriter agrees in writing that it will neither offer nor sell the bonds to any person at a price that is higher than the initial offering price to the public during the period ending on the earlier of (A) the close of the fifth business day after the sale date or (B) the date on which the underwriters have sold a substantial amount of the bonds to the public. By comparison, the 2015 proposed regulations include such a “hold-the-offering-price” requirement, but for a longer period extending to the issue date of the bonds.

Because of negative comments received, the IRS declined to retain a provision from the 2015 proposed regulations which would have allowed underwriters to sell bonds at higher than the initial offering price during the “hold-the-offering-price” period if the higher price was the result of market changes and appropriate documentation of the market changes was provided. Commenters had suggested that this rule was unworkable because of the absence of meaningful benchmarks for municipal bond prices.

In response to comments, the Final Regulations also adopt a special rule for bonds sold through a competitive sale process. Under this special rule, in the case of bonds issued for money pursuant to an eligible competitive sale, the issuer may treat the reasonably expected initial offering price to the public as the issue price for the bonds as of the sale date if the issuer obtains a certification from the winning bidder regarding the reasonably expected initial offering price to the public upon which the price in the winning bid is based (i.e., there is no requirement to hold the price for five days as in the case of negotiated sales of bonds). For this purposes, an eligible competitive sale must meet the following requirements: (i) the issuer disseminates the notice of sale to potential underwriters in a manner reasonably designed to reach potential underwriters, (ii) all bidders have an equal opportunity to bid, (iii) the issuer receives bids from at least three underwriters having established reputations for underwriting new issuances of municipal bonds, and (iv) the issuer awards the sale to the bidder who offers the highest price (or the lowest interest cost).

The Final Regulations also clarify the definition of “underwriter” for purposes of the issue price definition, providing that the term means (i) any person that agrees (individually or as part of a syndicate) pursuant to a written contract with the issuer to participate in the initial sale of the bonds to the public, and (ii) any person that agrees pursuant to a written contract with a person described in (i) above to participate in the initial sale of the bonds to the public (such as a retail distribution agreement).

The IRS received comments suggesting that issuers be permitted to conclusively rely on underwriter certifications to determine issue price, even if those certifications prove to be false. The IRS declined to adopt these comments in the Final Regulations, so that, e.g., an underwriter’s breach of its agreement not to sell bonds at a price higher than the initial offering price to the public will result in a redetermination of the issue price (and may cause the underwriter to be subject to penalties under section 6700 of the Code). In response to comments, the IRS also omitted from the Final Regulations certain language from the 2015 proposed regulations that would have imposed a higher level of due diligence on issuers with regard to the accuracy of certifications by underwriters.

Effective Date. The Final Regulations apply to bonds that are sold after June 7, 2017.

Impact of Final Regulations. The Final Regulations should result in greater certainty with regard to the determination of issue price. The main consequence of the Final Regulations will be the inclusion in virtually every bond purchase agreement for a negotiated sale an agreement of the underwriters that, in the event that a substantial amount of the bonds have not been sold as of the sale date, they will neither offer nor sell the bonds to any person at a price that is higher than the initial offering price to the public during the period ending on the earlier of (i) the close of the fifth business day after the sale date or (ii) the date on which the underwriters have sold a substantial amount of the bonds to the public. The impact of the Final Regulations on the use of competitive sales is not entirely clear. The more favorable rules for determining issue price in competitive sales may encourage issuers to use that type of underwriting, but the requirement to receive at least three bids in order to qualify for the special rule may discourage some issuers out of concern that in a particular transaction they may fail to receive the required three bids.