Tax Exempt Government Entitite Tax-Exempt Governmental Bond Publication 4079 (Rev. 9-2019) Catalog Number 34663R Department of the Treasury Internal Revenue Service www.irs.gov
| Tax Exempt Government Entitite Tax-Exempt Governmental Bond Publication 4079 (Rev. 9-2019) Catalog Number 34663R Department of the Treasury Internal Revenue Service www.irs.gov |
| Contents Introduction ............................................................................................................................. Background ............................................................................................................................. Tax-Exempt Governmental Bonds ......................................................................................... Other Governmental Bond Requirements ............................................................................. Post-Issuance Compliance Monitoring ................................................................................1 What To Do When You Discover a Violation TEB Voluntary Closing Ageement Program .......................................................................1 More Information ...................................................................................................................1 |
| Introduction This publication provides an overview of the federal tax law rules that apply to municipal financing arrangements commonly known as “governmental bonds.” It is intended to help issuers meet federal tax law requirements to ensure that interest earned by bondholders is exempt from taxation under Internal Revenue Code (IRC) Section 103. This publication is an overview of the rules; it isn’t official guidance that you may rely on for planning purposes. It refers to IRC sections, Income Tax Regulations (Treas. Regs.), revenue procedures and other official guidance. Please refer to the official guidance for the rules that apply to governmental bonds. Unless otherwise indicated, references in this publication to section numbers are references to sections of the IRC. For publications that discuss the general rules that apply to qualified 501(c)(3) bonds or other qualified private activity bonds, see IRS Publication 4077, Tax-Exempt Bonds for 501(c)(3) Charitable Organizations, and IRS Publication 4078, Tax-Exempt Private Activity Bonds. For an overview of an issuer’s responsibilities in a conduit financing arrangement, see IRS Publication 5005, Your Responsibilities as a Conduit Issuer of Tax-Exempt Bonds . For an overview of an issuer’s responsibilities with respect to arbitrage, See IRS Publication 5271, Complying with Arbitrage Requirements: A Guide for Issuers of Tax-Exempt Bonds . The IRS also provides more detailed information at IRS.gov/bonds. See also More Information , at the end of this publication. |
| Background State and local governments receive direct and indirect tax benefits under the IRC that lower borrowing costs on their valid debt obligations. Because interest paid to bondholders on these obligations is not includable in their gross income for federal income tax purposes, bondholders are willing to accept a lower interest rate than they would accept if the interest was taxable. These benefits apply to many different types of municipal debt financing arrangements including bonds, notes, loans, lease purchase contracts, lines of credit and commercial paper (collectively referred to as “bonds” in this publication). To receive these benefits, issuers must ensure that the requirements under the IRC are met, generally for as long as the bonds remain outstanding. These requirements include, but are not limited to, information filing and other requirements related to issuance, the proper and timely use of bond-financed property, and limitations on how bond proceeds (funds derived from the sale of bonds) may be invested. This publication describes these rules as they relate to governmental bonds. This publication also addresses practices and steps the issuer can take to protect the tax- exempt status of the bonds. For example, because the requirements and limitations generally apply at the time the bonds are issued and throughout the term of the bonds, this publication encourages issuers and beneficiaries of tax-exempt bonds to create procedures for monitoring compliance throughout the life of the bonds. For more information, see Post-Issuance Compliance Monitoring. Tax-Exempt Governmental Bonds Governmental bonds are bonds that do not meet the private activity bond tests. Proceeds of these bonds may be used to finance activities of, or facilities owned, operated or used by, the issuer for its purpose or another state or local government for its own purposes. This can include financing the construction, maintenance or repair of public infrastructure such as highways, schools, fire stations, libraries or other types of municipal facilities. To be tax-exempt, governmental bonds must comply with the requirements that define governmental bonds and requirements that apply to tax-exempt bonds generally. In this section, we discuss the tests for determining whether a bond is a governmental bond or a private activity bond. These tests apply at issuance and after the bonds are issued. This discussion includes remedial action provisions that apply when a deliberate action causes governmental bonds to become private activity bonds. If a deliberate action that results in a violation of any of the federal tax requirements cannot be corrected under the remedial action provisions, issuers may be able to enter into a closing agreement under the TEB Voluntary Closing Agreement Program (TEB VCAP) described in Notice 2008-31, 2008-11 I.R.B. 592 (see What To Do When You Discover a Violation — TEB Voluntary Closing Ageement Program ). |
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Testing for Governmental Bonds: The Private Activity Bond Tests
IRC Section 141 sets forth tests to determine if a bond is a private activity bond. These tests
identify arrangements that actually, or are reasonably expected to, transfer benefits of tax-
exempt financing to a nongovernmental person. A “nongovernmental person” is a person
other than a governmental person. A governmental person means a state or local government
as defined in Treas. Reg. Section 1.103-1 or any instrumentality of such entity. Governmental
persons do not include the United States or any agency or instrumentality of the United States.
A state or local bond will be a private activity bond if, as of the issue date of the bonds or at any
time while the bonds are outstanding, the bond issue exceeds the limits set forth in either:
the private business tests of Section 141(b), which consist of the private use test and the
private security and payment test, and certain special private business rules (see Special
Private Business Test Rules and Special Rules for Certain Utility Financings, below), o
the private loan financing test of Section 141(c).
The bond issue exceeds the private activity bond tests limits as of the issue date if the issuer
or a conduit borrower of the bond proceeds reasonably expects that the issue will exceed the
limits while the bonds are outstanding. A bond issue also exceeds the private activity bond tests
limits after the issue date if a deliberate action is taken that causes those limits to be exceeded.
If a bond is a private activity bond, interest on the bond may still be excludable from federal
income tax if the bond issue meets the additional requirements that apply to qualified private
activity bonds. For a discussion of these additional requirements, see Publication 4078, Tax-
Exempt Private Activity Bonds.
Private Business Tests
Under IRC Section 141(b), a bond issue exceeds the limits of the private business tests, and
therefore does not qualify as a governmental bond issue, if the issue exceeds the limit of the
private business use test and also exceeds the limit of the private security or payment test.
Private Business Use Test. A state or local bond issue exceeds the limit of the private business
use test if more than 10% of the proceeds of an issue are to be used for any private business
use. Use of bond proceeds or bond-financed property by a nongovernmental person (individual
or entity) in furtherance of a trade or business activity is considered private business use for tax-
exempt bond purposes. For this purpose, any trade or business activity of a natural person is
treated as a trade or business, and any activity carried on by a person (including a governmental
entity or corporation) other than a natural person is treated as a trade or business.
Indirect uses of proceeds must also be considered in determining whether more than 10% of the
proceeds of an issue will be used in a private business use. For example, property is treated as
being used for a private business use if it is leased to a nongovernmental person and then sub
leased to a governmental person if the nongovernmental person’s use is in a trade or business.
Many types of arrangements can result in private business use under IRC Section 141 at
issuance or later, including management and service contracts and research agreements.
Management and Service Contracts. Contracts for a private entity to manage a bond-financed
facility may cause the private business use test to be met. For example, a management
contract between a governmental entity and a nongovernmental person under which the
nongovernmental person receives compensation for services provided with respect to bond-
financed property may result in the bonds meeting the private business use test.
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| The IRS has provided safe harbors protecting against private business use for management and service contracts between a private entity and a governmental entity when the service is provided in connection with bond-financed property. For more information, see Revenue Procedure 2017-13. Contracts that fail the safe harbor do not automatically meet the private business use test; all facts and circumstances are considered to determine whether the contract meets the test. Research Agreements. Research agreements may also cause the private business use test to be met. For example, when private entities or the federal government sponsor research at a facility financed with tax-exempt bonds, the research agreements may result in the bonds meeting the private business use test. However, the IRS has provided safe harbors for research agreements. For more information, see Revenue Procedure 2007-47, 2007-29 I.R.B. 108. As with management contracts, failure to meet the safe harbors does not automatically cause the private business use test to be met. NOTE: If an issuer determines that its bonds meet the private business use test, the bonds have not met the private business tests unless the bonds also meet the private payment or security test. Private Security or Payment Test. A state or local bond exceeds the limit of the private security or payment test if more than 10% of the proceeds of the bond issue is (under the terms of the issue or any underlying arrangement) directly or indirectly (1) secured by any interest in property used or to be used for a private business use or payments in respect of the property, or (2) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use. For example, lease payments made by private businesses to a city for the lease of property in a blighted area that was rehabilitated with proceeds of the city’s bonds would be treated as private payments. NOTE: If an issuer determines that its bonds meet the private security or payment test, the bonds have not met the private business tests unless the bonds also meet the private business use test. Special Private Business Test Rules. Additional limits on private business activity apply when private business use is unrelated to the governmental use, when private business use is disproportionate to the governmental use, and when the “nonqualified amount” exceeds $15 million. Unrelated and Disproportionate Use. IRC Section 141(b)(3) provides an additional limit for unrelated and disproportionate business use, which is lower than the limits in Sections 141(b)(1) and 141(b)(2). In particular, it limits unrelated or disproportionate private use of assets financed with governmental bonds to 5% of the proceeds of the bonds. The rule also reduces the private security or payment test limit to 5%. For this purpose, only payments, property and borrowed money with respect to the unrelated or disproportionate use are taken into account. Unrelated use is private use that isn’t related to the governmental use of the issue. Whether a private business use is related to a government use financed with the proceeds of an issue is determined on a case-by-case basis, emphasizing the operational relationship between the government use and the private business use. In general, a facility that is used for a related private business use must be located within, or adjacent to, the governmentally-used facility. Example: A county issues bonds with proceeds of $20 million and uses $18.1 million of the proceeds for construction of a new school building and $1.9 million of the proceeds for 4 |
| construction of a privately operated cafeteria in its administrative office building, which is located at a remote site. The bonds are secured, in part, by the cafeteria. The $1.9 million of proceeds is unrelated to the governmental use (that is, school construction) financed with the bonds and exceeds 5% of $20 million. Thus, the issue exceeds the limit under the private business tests. A private business use is disproportionate to a related government use only to the extent that the amount of proceeds used for that private business exceeds the amount of proceeds of the issue used for the related government use. For example, a private use of $100 million of proceeds that is related to a government use of $70 million of proceeds results in $30 million of disproportionate use. When unrelated use and disproportionate use occur in the same bond issue, the two uses are aggregated to test against the 5% limit. Additional examples of the unrelated or disproportionate private use limits may be found in Treas. Reg. Section 1.141-9(e). Remedial Actions for Unrelated or Disproportionate Use. A deliberate action that occurs after the issue date does not result in unrelated or disproportionate use if the issue meets the remedial action provisions in Treas. Regs. Section 1.141-12(a), discussed in Remedial Actions for Nonqualified Use. The $15 Million Limit on the Nonqualified Amount. An additional limit may apply even though the “nonqualified amount” of proceeds does not exceed 10% of the proceeds of the bonds (or a lesser amount of unrelated or disproportionate use of proceeds), and therefore the private activity limits discussed above have not been exceeded. The nonqualified amount is the lesser of the amount of proceeds used in private business use or the amount of proceeds with respect to which there are private payments or security. Section 141(b)(5) provides that an issue of bonds will be private activity bonds if the nonqualified amount exceeds $15 million, unless the issuer applies state volume cap under Section 146 to the excess of the nonqualified amount over $15 million. For additional information on the state volume cap limit under Section 146, see Publication 4078, Tax-Exempt Private Activity Bonds. Special Rules for Certain Utility Financings. There are two additional limits that issuers of bonds for utility projects should consider. The first limit, under Section 141(b)(4), applies if 5% or more of the proceeds of the issue are to be used to finance any “output facility,” as defined in the regulations (other than a facility for the furnishing of water). Section 141(b)(4) limits the nonqualified amount of proceeds of a governmental bond issued to finance the output facilities to $15 million. This rule applies in addition to the tests under Section 141(b)(1) and (2). In applying this limit, issuers must include the nonqualified amounts on any prior outstanding tax-exempt bond issues for which 5% or more of the proceeds of the prior issue are or will be used for either the same output facility or another output facility that is part of the same project. If the nonqualified amount exceeds $15 million, the bonds are private activity bonds. Under the second limit, bonds will be private activity bonds if the amount of the proceeds of the issue that are to be used (directly or indirectly) for the acquisition by a governmental unit of nongovernmental output property exceeds the lesser of 5% of the proceeds or $5 million. “Nongovernmental output property” means any property (or interest therein) which before the acquisition was used (or held for use) by a person other than a governmental unit in connection with an output facility (other than a facility for the furnishing of water). The rule has several exceptions, which are beyond the scope of this publication. 5 |
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Private Loan Financing Test
A state or local bond exceeds the limit of the private loan financing test if the amount of
proceeds of the issue which is to be used (directly or indirectly) to make or finance loans to
persons other than governmental entities exceeds the lesser of 5% of the proceeds or $5 million.
A bond that exceeds the private loan financing test limit is a private activity bond, even if it does
not also meet the private business tests.
Exceeding the Private Activity Bond Tests Limits after Issuance
Even if the bonds comply with the limits of the private activity bond tests at issuance, a
governmental bond issue can lose its tax-exempt status (from the time of issuance) if the issuer
or a conduit borrower of the bond proceeds takes a “deliberate action” after the issue date
that causes the issue to exceed those limits. A deliberate action is any action taken by the
issuer or conduit borrower that is within its control; intent to exceed the limits is not necessary
for an action to be deliberate. A deliberate action occurs on the date the issuer or conduit
borrower enters into a binding contract (that is not subject to any material contingencies) with
a nongovernmental person for use of the bond-financed property in a manner that causes the
limits of the private activity tests to be exceeded.
Remedial Actions for Nonqualified Use. The regulations provide that an issuer and, in
conduit financings, a conduit borrower that engages in a deliberate action causing the limits
of the private activity bond tests to be exceeded may, in certain cases, cure that deliberate
action. Treas. Reg. Section 1.141-12 provides that an issuer may take remedial actions to cure
a deliberate action that would otherwise cause the bonds to lose their tax-exempt status. The
remedial actions include redemption or defeasance of nonqualified bonds, alternative use of
disposition proceeds and alternative use of bond-financed property.
Example: A city enters into an agreement through which it sells a building financed with
governmental bond proceeds to a corporation and leases the same building back from that
corporation, with the result that the corporation owns the building for federal income tax
purposes. This change in ownership of the property results in private business use and is a
deliberate action. However, the city may remediate the deliberate action by redeeming the
nonqualified bonds within 90 days of the action.
Other Governmental Bond Requirements
Other rules an issuer must meet for a governmental bond to be tax-exempt include:
rules a governmental bond must meet for interest to be excluded from federal income tax,
including rules that relate to issuance of the bonds (including elections that need to be made
when the bonds are issued) and rules that apply at issuance and throughout the life of the
bonds;
rules that apply when modifications are made to bond terms; and
recordkeeping requirements.
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Requirements Related to Issuance
The following is an overview of several general rules related to the issuance of governmental
bonds.
Issuers Must File an Information Return. Issuers of governmental bonds must comply with
certain information filing requirements under IRC Section 149(e). The size of the issuance
dictates which information return an issuer must file. The chart below describes what form
is required and when it must be filed. The IRS Forms listed below are available on the TEB
website.
Information Reporting Under Section 149(e)
Information Return Due Date Where to File
Form 8038-G, Information Generally, both returns are due on or File Form 8038-G and Form
Return for Tax-Exempt before the 15th day of the 2nd calendar 8038-GC information returns
Governmental Bonds , month after the close of the calendar at:
for a governmental bond quarter in which the bonds were Department of the Treasury
issue with an issue price of issued. Internal Revenue Service
$100,000 or greater. Example: The due date of the return Center
for bonds issued on February 1 is May Ogden, UT 84201
15.
Form 8038-GC, Information Alternatively, Form 8038-GC may
Return for Small Tax-Exempt be filed annually on a consolidated
Governmental Bond Issues , basis for all bond issues of less than
Leases, and Installment $100,000 that are not reported on
Sales, for a governmental a separate Form 8038-GC and that
bond issue with an issue are not construction issues electing
price of less than $100,000. to pay a penalty in lieu of rebate.
May be filed for a single Consolidated returns are due on or
issue or on a consolidated before February 15 following the
basis for all “small” issues in calendar year in which the bonds were
a calendar year. issued.
Example: An issuer issues three
governmental bond issues with issue
prices and dates as follows: $50,000
Issue A - March 1, 2018; $75,000 Issue
B - June 15, 2018; and $30,000 Issue
C - October 5, 2018. This issuer can
file one consolidated Form 8038-GC
by February 15, 2019 for all three bond
issues.
An issuer may request an extension of time to file Forms 8038-G or 8038-GC if the failure to file
the return on time wasn’t due to willful neglect. To request an extension, the issuer must follow
Revenue Procedure 2002-48, 2002-37 I.R.B. 531 . These procedures generally require that the
issuer: (1) attach a letter to the Form 8038-G or Form 8038-GC briefly explaining when the return
was required to be filed, why the return was not timely submitted, and whether the bond issue is
under examination; (2) enter on top of the letter “Request for Relief under section 3 of Rev. Proc.
2002-48” and (3) file the letter and return at the Internal Revenue Service Center, Ogden, UT
84201.
Bonds Must Be in Registered Form. IRC Section 149(a) generally provides that any tax-exempt
bond, including governmental bonds, must be issued “in registered form” unless the bond is not
of a type offered to the public or has, at the date of issue, a maturity of not more than one year.
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The regulations describe what it means to be in “registered form.” Treas. Reg. Section 5f.103
1(c)(1) provides that an obligation issued after January 20, 1987, pursuant to a binding contract
entered into after January 20, 1987, is in registered form if:
the obligation is registered as to both principal and any stated interest with the issuer (or
its agent) and that the transfer of the obligation to a new holder may be effected only by
surrender of the old instrument and the issuer must either reissue the old instrument or issue a
new instrument to the new holder, or
the right to the principal of, and stated interest on, the obligation may be transferred only
through a book-entry system maintained by the issuer (or its agent); or
the obligation is registered as to both principal and any stated interest with the issuer (or its
agent) and may be transferred through both the above methods.
Issuers Must Make Certain Elections at Issuance. When an issuer considers actions it must
take when it issues bonds, it should consider whether it wants to make any elections. Various
provisions of the IRC and regulations require that the issuer make certain elections in writing and
retain elections as part of the bond documents. Many elections have to be made on or before
the issue date of the bonds. Some elections may be made by either the issuer or a conduit
borrower. Others must be made by the actual issuer of the bonds. The IRS frequently observes
that issuers make the written elections in the arbitrage certificate prepared pursuant to Treas.
Reg. Section 1.148-2. Once made, elections cannot be revoked without IRS permission.
Examples of elections include:
waiving the right to treat a purpose investment as a program investment
waiving the right to invest in higher yielding investments during any temporary period
the issuer of a pooled financing issue electing to apply rebate spending exceptions separately
to each conduit loan
applying actual facts rather than reasonable expectations for certain provisions under the two-
year spending exception from rebate
excluding the earnings on a reasonably required reserve fund from available construction
proceeds under the two-year spending exception from rebat
treating a portion of an issue as a separate construction issue under the two-year spending
exception from rebate
electing to pay 1.5% penalty in lieu of arbitrage rebate
electing to treat portions of a bond issue as separate issues
Requirements that Apply at Issuance and Throughout the Life of the Bonds
Proceeds Must Be Timely Allocated to Expenditures. Issuers and conduit borrowers must
follow the rules for allocating bond proceeds. The issuer or other entity controlling expenditure
of the proceeds of a governmental bond issue must allocate those proceeds among the various
expenditures or other purposes of the issue in a manner demonstrating that the private activity
bond tests are not met. These allocations must generally be consistent with the allocations
made for determining compliance with the arbitrage yield restriction and rebate requirements,
as well as other federal tax filings. See Proceeds are Subject to Investment Restrictions: the
Arbitrage Yield Restriction and Arbitrage Rebate Requirements for an overview of those rules.
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| An issuer must allocate proceeds to expenditures not later than 18 months after the later of the date each expenditure is paid or the date the project, if any, that is financed by the issue is placed in service. This allocation must be made in any event by the date 60 days after the fifth anniversary of the issue date or the date 60 days after the retirement of the issue, if earlier. Proceeds are Subject to Investment Restrictions: the Arbitrage Yield Restriction and Arbitrage Rebate Requirements. Issuers of tax-exempt bonds, including governmental bonds, are generally subject to investment or arbitrage limitations under IRC Section 148. Failure to comply with those arbitrage limitations will result in the bonds being arbitrage bonds and interest on the bonds being taxable. In general, arbitrage is earned when the gross proceeds of an issue are used to acquire investments that earn a yield that is materially higher than the yield on the bonds of the issue. Earning arbitrage is permitted in certain circumstances. In some circumstances arbitrage may be earned but must be paid, or rebated to the U.S. Department of the Treasury. In some cases, an issuer may be able to reduce the yield on an investment for arbitrage purposes and thereby avoid an arbitrage violation by making a yield reduction payment to the U.S. Treasury. See Where and When to File Arbitrage Rebate Yield Reduction Payments , for information on how to make yield reduction payments. An issuer must comply with two general sets of arbitrage rules: (1) the yield restriction requirements of Section 148(a) and (2) the rebate requirements of Section 148(f). An issuer may meet one of these rules but still have arbitrage bonds because it failed to meet the other. Even though interconnected, both sets of rules have their own distinct requirements. The following is an overview of the basic requirements of these two general rules. Additional requirements or exceptions, beyond the scope of this publication, may apply in certain instances. An issuer’s reasonable expectations on the issue date regarding the amount and use of gross proceeds of the issue are used to determine whether an issue consists of arbitrage bonds. In addition, if an issuer or any person acting for the issuer takes a deliberate, intentional action to earn arbitrage after the issue date, that action will cause the bonds of an issue to be arbitrage bonds if that action, had it been reasonably expected on the issue date, would have caused the bonds to be arbitrage bonds. Intent to violate the requirements of Section 148 is not necessary for an action to be intentional. Yield Restriction Requirements. The yield restriction rules of IRC Section 148(a) generally provide that the direct or indirect investment of the gross proceeds of bonds in investments earning a yield materially higher than the yield of the bond issue causes the bonds to be arbitrage bonds. The chart below describes when the yield on particular investments will be “materially higher” (the chart shows the permitted yield spread between the yield on the bond issue and the yield on the particular investment; any spread beyond that stated is materially higher): 9 |
| “Materially Higher” Limits Type of Investments Materially Higher General rule (when other rules below don’t apply) 1/8 of one percentage point Investments in a refunding escrow 1/1000 of one percentage point Investments allocable to replacement proceeds 1/1000 of one percentage point Program investments 1.5 percentage points Investments in tax-exempt bonds that are not No yield limitation subject to the alternative minimum income tax Certain exceptions are available under the yield restriction rules. The investment of proceeds in materially higher yielding investments does not cause the bonds of an issue to be arbitrage bonds: (1) during a temporary period (for example, three-year temporary period for capital projects and 13 months for restricted working capital expenditures); (2) as part of a reasonably required reserve or replacement fund; and (3) as part of a minor portion (an amount not exceeding the lesser of 5% of the sale proceeds of the issue or $100,000). Whether the arbitrage yield restrictions rules apply, issuers should consider whether the rebate requirements apply. Rebate Requirements. The rebate requirements of IRC Section 148(f) generally provide that, unless certain earnings on “nonpurpose investments” allocable to the gross proceeds of an issue are rebated to the U.S. Treasury, the bonds in the issue will be arbitrage bonds. Generally, nonpurpose investments are investment securities such as Treasury bonds, bank deposits or guaranteed investment contracts, and so on, and do not include “purpose investments.” A purpose investment is an investment that the issuer acquires to carry out the governmental purpose of an issue. An example of a purpose investment is the loan obligation created when an issuer loans bond proceeds to another governmental unit, such as in a pooled or “bond bank” financing. The arbitrage that must be rebated is based on the excess (if any) of the amount actually earned on nonpurpose investments over the amount that would have been earned if those investments had a yield equal to the yield on the issue, plus any income attributable to the excess. Under Treas. Reg. Section 1.148-3(b), the future values (as of the computation date) of all earnings received and payments actually or constructively made on nonpurpose investments are included in determining the amount of rebate due. See Where and When to File Arbitrage Rebate Yield Reduction Payments for information on how to make rebate payments. There are, however, two types of exceptions to the general rebate requirements that apply to governmental bonds: the small issuer exception and the spending exceptions. Small Issuer Exception. This exception provides that governmental bonds issued by small governmental issuers with general taxing powers are treated as meeting the arbitrage rebate requirement. A governmental entity has general taxing powers if it has the power to impose taxes of general applicability which, when collected, may be used for its general purposes. 10 |
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An issue (other than a refunding issue, for which other rules apply) qualifies for the small issuer
exception only if the issuer reasonably expects as of the issue date to issue, or in fact issues,
$5 million or less in tax-exempt governmental bonds during the calendar year. The aggregation
rules of Section 148(f)(4)(D) should be considered when determining whether this exception
applies. The $5 million limit is increased by the aggregate face amount of bonds attributable to
financing the construction of public school facilities, up to an additional $10 million. For example,
the small issuer exception could apply if the qualifying issuer issued $5 million in tax-exempt
governmental bonds for street improvements and $5 million in tax-exempt bonds to finance
construction of public school facilities in the same calendar year.
An issue meeting the small issuer requirements is exempt from rebate for all gross proceeds.
However, the small issuer exception is an exception from rebate and not from the arbitrage rules
altogether. The yield restriction rules still apply. Therefore, an issuer qualifying for this exception
needs to establish a temporary period for project fund investments and needs to establish that
any reserve fund is reasonably required.
Spending Exceptions. There are three spending exceptions to the rebate requirements. Whether
these exceptions apply depends on the timing of expenditures of required amounts of proceeds,
as follows:
Spending Exceptions
Spending Spending Exception
Period
6 months Treas. Reg. Section 1.148-7(c) provides an exception to rebate if the gross proceeds
of the bond issue are allocated to expenditures for governmental or qualified
purposes that are incurred within 6 months after the issue date.
18 months Treas. Reg. Section 1.148-7(d) provides an exception to rebate if the gross proceeds
of the bond issue are allocated to expenditures for governmental or qualified
purposes which are incurred within: (1) at least 15% within 6 months after the issue
date; (2) at least 60% within 12 months after the issue date; and (3) 100% within 18
months after the issue date.
2 years Treas. Reg. Section 1.148-7(e) provides an exception to rebate for construction issues
financing property to be owned by a governmental entity or 501(c)(3) organization
when certain available construction proceeds are allocated to expenditures: (1) at
least 10% within 6 months after the issue date; (2) at least 45% within 12 months
after the issue date; (3) at least 75% within 18 months after the issue date; and (4)
100% within 24 months after the issue date.
Note: Issuers may still owe rebate on amounts earned on nonpurpose investments allocable to proceeds
not covered by one of the spending exceptions, which may include earnings in a reasonably required
reserve or replacement fund.
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Where and When To File Arbitrage Rebate and Yield Reduction Payments . Issuers of tax-exempt
bonds file Form 8038-T, Arbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage
Rebate, to make:
yield reduction payments
arbitrage rebate payments
payments of a penalty in lieu of rebate
payment in connection with the termination of the election to pay a penalty in lieu of arbitrage
rebate
payment of the penalty for failure to pay arbitrage rebate on time
A yield reduction payment or arbitrage rebate installment payment is required to be paid no
later than 60 days after the “computation date” to which the payment relates. An issuer of a
fixed yield issue may treat any date as a computation date. An issuer of a variable yield issue
may treat the last day of any bond year ending on or before the latest date for making the first
rebate payment (generally not later than five years after the issue date) as a computation date.
Thereafter, the issuer must consistently treat either the end of each bond year of the end of each
fifth bond year as a computation date. Generally, a “bond year” is a one-year period that ends
on the date that the issuer selects. If the issuer does not make a timely selection, the bond years
for the issue end on each anniversary of the issue date and on the final maturity date.
Recovering an Overpayment of Rebate. If an issuer pays more than the required rebate, it may
ask to recover the overpayment. In general, an issuer may request an overpayment of arbitrage
rebate when it can establish that an overpayment occurred. An overpayment is the excess of
the amount paid to the U.S. Treasury for an issue under IRC Section 148 over the sum of the
rebate amount for the issue as of the most recent computation date and all amounts that are
otherwise required to be paid under Section 148 as of the date the recovery is requested. The
request can be made with the IRS by completing and filing Form 8038-R, Request for Recovery
of Overpayments Under Arbitrage Rebate Provisions . An issuer must file a Form 8038-R no
later than the date that is two years after the final computation date for the issue. For more
information, see Treas. Reg. Section 1.148-3(i).
Special Remedial Action for Failure to Timely Pay Arbitrage Rebate . An issuer that fails to timely
pay arbitrage rebate will be excused from having its bonds be arbitrage bonds if the failure isn’t
due to willful neglect and the issuer submits a Form 8038-T with a payment of the rebate amount
owed, plus penalty and interest. The penalty may be waived under certain circumstances. For
more information, see Treas. Reg. Section 1.148-3(i)(3) and Revenue Procedure 2005-40, 2005
28 I.R.B. 83.
Bonds May Not Be Federally Guaranteed. IRC Section 149(b) provides that any tax-exempt
bond, including a governmental bond, will not be treated as tax-exempt if the payment of
principal or interest is directly or indirectly guaranteed by the federal government or any agency
or instrumentality of the federal government. Exceptions to this general rule include guarantees
by certain quasi-governmental entities administering federal insurance programs, and federal
guarantees for qualified residential rental projects, home mortgages and student loans. Additional
exceptions apply for the investment of bond proceeds that are invested in U.S. Treasury securities
or held in a bona fide debt service fund, a reasonably required reserve or replacement fund or a
refunding escrow, and investments during a permitted initial temporary period.
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A Bond May Not Be a Hedge Bond . IRC Section 149(g) states that hedge bonds will not be
tax-exempt unless certain requirements, described below, are satisfied. A “hedge bond” is any
bond that is part of a bond issue that fails either of the following requirements:
The issuer must reasonably expect that 85% of the spendable proceeds of the issue will be
used to carry out the qualified purpose within the three-year period beginning on the date the
bonds are issued (“spendable proceeds” means proceeds from the sale of the issue, less the
portion invested in a reasonably required reserve or replacement fund or as part of a permitted
“minor portion”).
Not more than 50% of the proceeds of the issue are invested in nonpurpose investments
having a substantially guaranteed yield for four or more years.
Section 149(g)(3)(B) provides an exception to the general definition of a hedge bond if at least
95% of the net proceeds of the issue are invested in tax-exempt bonds that are not subject
to the alternative minimum tax. For this purpose, amounts held either: (1) in a bona fide debt
service fund, or (2) for 30 days or less pending either reinvestment of the proceeds or bond
redemption, are treated as invested in tax-exempt bonds not subject to the alternative minimum
tax. Additionally, a refunding bond issue does not generally consist of hedge bonds if the prior
issue met the requirements for tax-exempt status and issuance of the refunding bonds furthers a
significant governmental purpose (for example, realize debt service savings, but not to otherwise
hedge against future increases in interest rates).
Even if an issue otherwise meets the definition of a hedge bond, it will generally still be tax-
exempt if two requirements are satisfied. First, at least 95% of the reasonably expected legal
and underwriting costs associated with issuing the bonds must be paid within 180 days after
the issue date and the payment of such costs must not be contingent upon the disbursement of
the bond proceeds. Second, on the date of issuance the issuer must reasonably expect that the
spendable proceeds of the issue will be allocated to expenditures for governmental or qualified
purposes within the following schedule:
10% within 1 year after the date of issuance;
30% within 2 years after the date of issuance;
60% within 3 years after the date of issuance; and
85% within 5 years after the date of issuance.
Limitations on Refunding Governmental Bonds. Governmental bonds may be currently
refunded. The Tax Cuts and Jobs Act (2017) repealed the exclusion from gross income for
interest on bonds issued to advance refund another bond. The repeal applies to advance
refunding bonds issued after December 31, 2017. A bond is classified as an advance refunding if
it is issued more than 90 days before the redemption of the refunded bonds. Under Treas. Reg.
Section 1.150-1(d)(1), a refunding bond issue is an issue the proceeds of which are used to pay
principal, interest, or redemption price on another issue (a prior issue), as well as the issuance
cost, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund,
or any similar cost properly allocable to that refunding issue.
Refunding issues generally derive their tax-exempt status from the prior issue they refund; if the
prior issue was not tax-exempt, the refunding bonds generally cannot be tax exempt.
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| Bonds May Not Be Used for Abusive Tax Transactions The IRS, is engaged in extensive efforts to curb abusive tax shelter schemes and transactions. What Happens When the Terms of a Bond are Modified? If the terms of a governmental bond are sufficiently modified, the bond will be treated as reissued. When bonds are reissued, either actually or in a deemed reissuance, the new bonds must be retested as of the date of the reissuance to determine if all the federal tax requirements are met for the “new” issue. These include the requirements that apply when bonds are issued, such as timely filing of the Form 8038-G or 8038-GC. See Requirements Related to Issuance – Issuers Must File an Information Return. A deemed reissuance may arise if sufficient changes are made to the bond terms, such as when a bondholder and issuer agree, directly or indirectly, to a significant modification of the terms of any bonds. See Reissuance of Tax-Exempt Obligations: Some Basic Concepts for examples of significant modifications. If deemed reissued, the modified bonds are deemed exchanged for the original bonds. In general, the date the issuer and bondholder enter into the agreement to modify the terms of the bonds is treated as the date of issuance of the new bonds, even if the modification is not immediately effective. At reissuance, the modified bond must meet any tax law requirements that apply upon its early retirement in connection with the reissuance, including the acceleration of any arbitrage rebate or yield reduction payment that is due. See Where and When To File Arbitrage Rebate and Yield Reduction Payments. Issuers Must Retain Records to Show that Requirements are Satisfied IRC Section 6001 and Treas. Reg. Section 1.6001-1(a) generally provide that any person subject to income tax, or any person required to file a return of information with respect to income (for example, the issuer filing information returns relating to its bond issues), must keep any books and records as are sufficient to establish the amount of gross income, deductions, credits or other matters required to be shown by that person in any return. See Frequently Asked Questions for more information. Post-Issuance Compliance Monitoring In this section, we discuss the importance of issuers monitoring compliance with the IRC requirements and suggest steps an issuer may take to monitor its bond issues. Protecting Against Post-Issuance Violations Issuers may be concerned with how they can further protect the tax-exempt status of their bonds. Reliance solely on bond documents and tax certificates provided when the bonds are issued will not likely provide the assurance an issuer desires. To gain greater confidence that bonds are in compliance with federal tax laws, an issuer may adopt post-issuance monitoring procedures. Issuers that establish and follow comprehensive written monitoring procedures to promote post-issuance compliance generally are less likely to violate the federal tax requirements related to its bonds, and are more likely to find any violations earlier, than those without procedures. Early discovery of a violation is a factor IRS considers in determining the appropriate resolution under its TEB VCAP. 1 |
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Steps to Better Monitoring
In formulating its procedures, an issuer may consider:
designating one or more officials to assist in post-issuance compliance;
designating one or more officials to assist with and respond to examinations of the bond issue;
providing training or other technical support to designated officials;
designating time intervals within which compliance monitoring activities will be completed; and
timely completing remedial actions (including requests under TEB VCAP) to correct or
otherwise resolve identified noncompliance
The chart below identifies particular areas for compliance monitoring procedures.
Compliance Procedures
Type of Description of Procedures for Where Responsibility Is
Procedures Post -Closing Matters Discussed in this Publication
Information Procedures to ensure timely filing Other Governmental Bond Requirements –
Return Filing of information returns, including Requirements Related to Issuance – Issuers
procedures concerning amended Must File an Information Return
and late filed returns
Private Use of Procedures to timely identify and Tax-Exempt Governmental Bonds – Testing for
Proceeds or remediate deliberate actions Governmental Bonds: The Private Activity Bond
Bond-Financed Tests
Property
Reissuance Procedures to satisfy tax Other Governmental Bond Requirements –
requirements when a significant What Happens When the Terms of a Bond Are
modification in terms results in a Modified?
reissuance for federal income tax
purposes
Elections Procedures for timely federal Other Governmental Bond Requirements –
income tax elections Requirements Related to Issuance – Issuers
Must Make Certain Elections at Issuance
Allocation of Procedures for the timely Other Governmental Bond Requirements –
Proceeds expenditure and accounting Requirements that Apply at Issuance and
for use and investment of bond Throughout the Life of the Bonds – Proceeds
proceeds Must be Timely Allocated to Expenditures
Arbitrage Procedures for the timely Other Governmental Bond Requirements –
Compliance computation and payment Requirements that Apply at Issuance and
of arbitrage rebate and yield Throughout the Life of the Bonds – Proceeds
reduction payments are Subject to Investment Restrictions: the
Arbitrage Yield Restriction and Arbitrage Rebate
Requirements
Record Procedures for the maintenance Other Governmental Bond Requirements –
Retention of records Issuers Must Retain Records to Show that
Requirements are Satisfied
IRS Contacts Procedures concerning contacts Post-Issuance Compliance Monitoring – Steps to
from the IRS Better Monitoring
See Post-Issuance Compliance for additional information.
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| What To Do When You Discover a Violation — TEB Voluntary Closing Ageement Program The IRS is committed to resolving federal tax violations with the issuer. The TEB Voluntary Closing Agreement Program (TEB VCAP) provides remedies for issuers of tax-exempt bonds, tax credit bonds, and direct pay bonds that voluntarily come forward to resolve a violation that cannot be corrected under self-correction programs described in the regulations or other published guidance. Notice 2008-31, 2008-11 I.R.B 592, provides information and general guidance about TEB VCAP. Internal Revenue Manual (IRM) section 7.2.3 provides general procedures under which TEB will enter into closing agreements. Closing agreement terms and amounts may vary according to the degree of the violation as well as the facts and circumstances surrounding it. Issuers must use IRS Form 14429, Tax Exempt Bonds Voluntary Closing Agreement Program Request, to submit a request and provide the required information. See IRM section 7.2.3.2.1 about completing the March 2013 version of the form. For more information about this program, including request submission requirements, case processing procedures, and resolutions standards, see IRM section 7.2.3 . See Voluntary Compliance (for more information on TEB VCAP administrative procedures and resolution standards). More Information You can find information about the tax laws that apply to municipal finance arrangements, including tax forms and instructions, revenue procedures and notices, and publications at IRS.gov/bonds. If you have account specific questions, call Customer Account Services toll-free at 877-829-5500. 1 |