From time to time, issuers will use bond proceeds to make grants to accomplish a governmental purpose. For example, a State bond issuer may make grants to various counties and cities to help with the cost of local transportation improvements. Under the arbitrage regulations (Reg. 1.148-6(d)(4)), the bond proceeds are treated as spent once an issuer makes a grant of bond proceeds to an unrelated party, so long as it is truly a grant (and not an advance that must be repaid). This means that the issuer can stop monitoring the investment yield that it receives from those proceeds once it makes the grant.`
Contrast this with the case in which an issuer transfers bond proceeds to a recipient in the form of a loan. In that case, the loan will be treated as an investment of bond proceeds. This means that the issuer must continue to monitor the investment yield that it receives on the loan, in the form of debt service payments from the recipient. In addition, in the case of a loan, it is clear under other provisions that apply to tax-exempt bonds that the issuer must look through to examine what the loan recipient does with the proceeds that it receives. For example, the issuer must look through to the status of the loan recipient as a governmental person or a private person for purposes of the private business use rules. However, once the loan recipient then spends the bond proceeds on something that counts as an expenditure under the arbitrage rules (for example, by paying them to a construction company in exchange for the company’s services in building capital assets of the bond-financed project), at that point the bond proceeds are treated as spent for the purpose to which the loan recipient applied them. In other words, neither the issuer nor the loan recipient would need to look through to examine how the construction company invested and spent the proceeds that were transferred.
Prior to 2013 proposed arbitrage regulations covering the point, the Code and Treasury Regulations were silent on how to treat bond proceeds that are used to make a grant for purposes other than when to treat the proceeds as spent for arbitrage purposes. Faced with this silence, issuers or conduit borrowers that made a grant of bond proceeds had basically two choices: (1) treat the arbitrage rule as applying for all tax-exempt bond purposes, so that once the issuer or conduit borrower made the grant, the grant recipient would be treated like the construction company in the above example (for example, its identity as a private person would not affect the private business use analysis, and its further investment and use of the proceeds could not affect the tax status of the bonds that financed the grant), or (2) treat the arbitrage rule as applying for arbitrage purposes relating to the timing of the expenditure of bond proceeds (and any purposes that explicitly tie to that arbitrage treatment, such as the “hedge bond” rules (see Reg. 1.149(g)-1(b)), but look through to the grantee’s use for other purposes, such as private business use. (One supposes that a particularly cheeky issuer might have cherrypicked Choice (1) or (2) depending on the tax issue in question, but we will rule that out in the interest of good manners.)