The IRS recently announced on its website a new closing agreement program under the arbitrage rules applicable to tax-exempt bonds for so-called "forward float" agreements utilized in advance refunding escrows. Under the program, issuers will be considered to have acquired such an investment at fair market value if the up-front payment received by the issuer under the forward float agreement is not less than 80 percent of the amount determined using a pricing model provided by the IRS based upon implied forward interest rates derived from the yield curve for U.S. Treasury obligations. The closing agreement program also confirms that such forward float investments purchased in compliance with the existing bidding safe harbor under the Treasury Regulations will be considered purchased at fair market value.

Background. When bonds are issued to refinance a prior issue, and principal or interest on the prior issue will be paid more than 90 days after issuance of the new refunding bonds, the new bonds will be considered an "advance refunding" of the prior bonds. Proceeds of such an issue are generally invested in an advance refunding escrow to be used to pay principal and interest on, and redemption price of, the prior bonds. Under the arbitrage provisions of Section 148 of the Internal Revenue Code, proceeds of the refunding issue invested in the advance refunding escrow generally may not be invested at yield that is higher than the yield on the refunding issue.

Advance refunding escrows are sometimes invested in a portfolio of United States Treasury obligations. It is not always possible to have the investments in the escrow maturing on precisely the same dates that amounts will be needed to pay principal or interest on the prior bonds, so amounts potentially will sit un-invested in the escrow for such periods of time. In order to avoid this inefficiency, the issuer may enter into a forward float agreement with an investment provider, under which the issuer typically will receive an up-front payment in exchange for giving the investment provider the right to invest the proceeds during the float periods. The up-front payment received by the issuer must be taken into account in computing the yield on the advance refunding escrow for purposes of the arbitrage rules.

A long-standing concern of the IRS is that impermissible arbitrage earnings on an advance refunding escrow may be deflected to the investment provider if the issuer purchases investments in the escrow at greater than fair market value. This has been commonly referred to as "yield burning." In the context of a forward float agreement, such yield burning would occur if the up-front payment to the issuer were less than fair market value. For many years the Treasury Regulations have provided a "safe harbor" under which issuers that purchase certain investments in compliance with specified bidding procedures will be considered to have purchased such investments at fair market value.

New Voluntary Closing Agreement Program. In announcing the new voluntary closing agreement program, the IRS confirmed that forward float agreements acquired in accordance with the bidding procedures set forth in the Treasury Regulations are treated as acquired at fair market value.1

In the case of forward float agreements that were not acquired through such a bidding process, the new program provides that an issuer will be treated as acquiring the forward float agreement at fair market value if the up-front payment to the issuer is at least 80 percent of the amount determined under a pricing model developed by the IRS that is based upon implied forward interest rates derived from the yield curve for U.S. Treasury obligations. Under the program, if the amount received by an issuer for a forward float agreement for an advance refunding escrow is less than 80 percent of the amount determined under the model, the issuer may enter into a voluntary closing agreement with the IRS under which the issuer must make a payment to the IRS in an amount necessary to bring the recomputed yield on the advance refunding escrow into compliance with the yield restriction requirements under Section 148 utilizing the IRS's valuation methodology.

It is important to note that this program is only available until March 1, 2008. Thus, issuers who have acquired forward float agreements for advance refunding escrows without utilizing the applicable bidding procedures have only a limited time to enter into a voluntary closing agreement with the IRS under the terms of the program. The IRS may demand higher settlement amounts after March 1, 2008.

Conclusion. Issuers of tax-exempt bonds that have entered into forward float agreements for advance refunding escrows should carefully review whether such investments were acquired in compliance with the bidding safe harbor provided in the Treasury Regulations. If the agreement was not acquired through such a procedure, issuers should consult with their tax counsel over whether the agreement meets the 80-percent test based on the valuation methodology provided by the IRS under the new program. If the 80-percent test is not met, issuers should consider contacting the IRS prior to March 1, 2008, to discuss entering into a voluntary closing agreement.