The Issue Spot: "Spend Down" Rules
The Issue Spot PUBL I C F I NANCE I N FOCUS
“Spend Down” Rules The federal government views tax-exempt interest as a subsidy to state and local governments because it is foregoing the income tax revenue that otherwise would have to be paid on taxable interest earnings. As a result, both the Internal Revenue Code of 1986, as amended (the “Code”) and the Treasury Regulations promulgated thereunder (the “Regulations”) set forth a number of rules meant to ensure that issuers are not, as section 1.148 10 of the Treasury Regulations provides, “issuing more bonds, issuing bonds earlier, or allowing bonds to remain outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes of the bonds, based on all the facts and circumstances.” One way that federal tax law seeks to curb these enumerated abuses is through various provisions that set forth “spend-down” requirements for proceeds (including investment earnings) of tax-exempt bonds that will be used for capital projects.
◊ Proceeds of bonds are generally “spent” on capital projects when they are paid to an unrelated third party.
Qualifications for Temporary Period
The Code and Regulations contain a number of rules relating to “arbitrage,” or the investment of tax-exempt proceeds in taxable investments. Generally, these rules require that an issuer restrict its investment of tax-exempt proceeds to a yield that is not materially higher than the yield on the bonds. In a positive arbitrage environment (one in which investment yields are higher than the bond yield), it can be administratively challenging for an issuer to manage its investments to remain in compliance with these rules. Acknowledging this administrative burden, section 1.148-2(e)(2) of the Regulations provides for a “temporary period” of 3 years (the “3-year temporary period”) for proceeds of tax-exempt bonds that are reasonably expected to be allocated to capital projects. During the 3-year temporary period, an issuer need not yield restrict such proceeds. To qualify for the 3-year temporary period, however, an issuer must reasonably expect to allocate at least 85% of the sale proceeds to capital projects within 3 years from the issue date of the bonds. The issuer must also reasonably expect that the projects will proceed with due diligence and that, within 6 months of such issue date, the issuer will enter into a binding obligation with a third party to expend at least 5% of the net sale proceeds.
◊ If the issuer does not reasonably expect to meet these requirements, the bonds will not necessarily become taxable, but the issuer must more actively monitor and manage its investment yields.
Even though the 3-year temporary period allows an issuer to invest proceeds in investments with a higher yield than that of the bonds, federal tax law generally requires the issuer to give back, or “rebate,” to the federal government any investment earnings that are in excess of what would have been earned if the issuer had invested the proceeds at the bond yield. However, the Code and Regulations provide that an issuer need not rebate amounts to the federal government if it meets one of the exceptions set forth below. Construction Bond Exception In general, if at least 75% of the proceeds of an issue will be allocated to construction expenditures (excluding land), an issuer may qualify for a rebate exception under section 148(f)(4) of the Code if it meets the following spend-down schedule: • 10% of the construction proceeds (including investment earnings, but excluding proceeds used for costs of issuance or a reserve fund) spent within 6 months; • 45% of such proceeds spent within 1 year; • 75% of such proceeds spent within 18 months; and • 100% of such proceeds spent within 2 years. 6-Month Exception An issuer may qualify for a rebate exception under section 148(f)(4) of the Code if the issuer spends 100% of the proceeds of the bonds with 6 months of issuance. 18-Month Exception An issuer may qualify for a rebate exception under section 1.148-7(d) of the Regulations if the issuer meets the following spend-down schedule:
• 15% of such proceeds spent within 6 months; • 60% of such proceeds spent within 12 months; and • 100% of such proceeds spent within 18 months.
The spend-down requirements set forth in the various exceptions above are based on actual facts and not reasonable expectations. If the issue does not meet the spend-down requirements, the issuer may be required to rebate excess earnings to the federal government.
Hedge Bond Rules (section 149(g)(2) of the Code)
To avoid an issue of bonds being classified as “hedge bonds,” the interest on which is not tax-exempt, an issuer must reasonably expect that 85% of the spendable proceeds of the bonds will be used to carry out the governmental purposes of the issue within three years of the issuance of the bonds. If the issuer does not reasonably expect to meet this requirement, then tax counsel must review the facts and circumstances to determine whether the bonds will be classified as hedge bonds and, if so, meet a more detailed spend-down calendar.
IRS Enforcement Efforts
In the course of assisting issuers with response to IRS audits in recent years, we have observed that the IRS has routinely requested information regarding how quickly an issuer has spent proceeds of tax-exempt bonds. Additionally, when an issuer has had unspent proceeds, the IRS has closely scrutinized the stated cause of the unspent proceeds and the reasonableness of the issuer’s expectations on the issue date of the bonds to
determine whether the issuer issued bonds in excess of what was needed or earlier than necessary to achieve the governmental purposes of the bonds.
If the ultimate facts are such that an issuer cannot spend the proceeds in accordance with the timeline expected at closing, we recommend that records be kept regarding changes in circumstance and efforts being made to spend the proceeds expediently.
Bracewell LLP makes this information available for educational purposes. This information does not offer specific legal advice or create an attorney client relationship with the firm. Do not use this information as a substitute for specific legal advice. © 2023 Bracewell LLP. Attorney advertising.
Victoria N. Ozimek Partner Austin
Brian P. Teaff Partner Houston
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