A Summary of the Final Regulations on Non-Issue Price Arbitrage Restrictions

On July 18, 2016, the Treasury Department published final regulations on non-issue price arbitrage restrictions (the “Final Regulations”) in the Federal Register. The Final Regulations finalize regulations proposed in 2007 and 2013 (collectively, the “Proposed Regulations”). Click here for a copy of the Final Regulations, and read below for a high-level summary of them. We will in subsequent posts be publishing more detailed analysis of specific provisions in the Final Regulations.

As discussed in a prior post, the Final Regulations apply to bonds sold on or after October 17, 2016 (the “Effective Date”). References in this blog post to “Prior Regulations” are references to the Treasury Regulations in effect prior to the Effective Date of the Final Regulations.

The Final Regulations make changes to a number of rules scattered throughout the arbitrage regulations. Below, we take them in order, progressing through the Final Regulations. To facilitate your review, at the end of this post is a comparison table showing certain provisions of the Final Regulations next to the parallel provisions in the Prior Regulations.

Definitions and Elections (Regulations 1.148-1)

Working Capital Expenditures and Replacement Proceeds Definition

The arbitrage regulations place several restrictions on the use of tax-exempt bond proceeds to finance working capital expenditures. One such restriction is through the creation of “replacement proceeds.” Replacement proceeds, and the attendant need to comply with the arbitrage regulations when investing such proceeds, arise when (i) the term of the tax-exempt bond issue is longer than reasonably necessary for the governmental purposes of the bond issue and (ii) the issuer has other amounts available to it that could have paid the expenditures financed by the tax-exempt bond issue.

The Final Regulations extend the short-term safe harbor against the creation of replacement proceeds to apply to all working capital expenditures as opposed to only “restricted” working capital expenditures. In so doing, the Regulations now permit application of the safe harbor to extraordinary and de minimis working capital expenditures. To align the safe harbor with the temporary period for working capital expenditures (Regulation § 1.148-2(e)(3)), the revised safe harbor shortens the bond maturity that will qualify for the safe harbor from 2 years to 13 months.(1)[1]

The Final Regulations adopt a new safe harbor against the creation of replacement proceeds for long-term working capital financings as long as the issuer applies “available amounts” on hand prior to maturity, if any, to redeem bonds or invest in eligible tax-exempt bonds (each of which has the effect of reducing the burden on the tax-exempt market).[2] Specifically, replacement proceeds do not arise in a long-term working capital financing if the issuer (a) determines the first year in which it expects to have available amounts for working capital expenditures (this first year can be no later than five years after the issue date of the bonds), (b) monitors for actual available amounts in each year beginning with the first year it first expects to have such amounts, and (c) applies such amounts in each year either to redeem or to invest in (or some combination of both) in certain tax-exempt bonds.

Available amounts are tested on the first day of the issuer’s fiscal year irrespective of the issuer’s cash positions on particular dates and potential expected short-term cash needs to finance governmental purposes. Many commenters had asked for greater flexibility with respect to the timing of testing the yearly available amounts based on considerations associated with potential unrepresentative cash positions. Although the Final Regulations contain certain provisions designed to address concerns raised by the testing date, the retention of the fixed testing date will significantly inconvenience many issuers.(2)

Finally, the definition of available amounts is amended to consider issuers that have used proceeds of more than one outstanding bond issue to finance working capital expenditures. Under the Final Regulations, available amounts exclude the proceeds of any issue of tax-exempt bonds, not just the particular issue for which available amounts is being determined. (3)

General Arbitrage Yield Restriction Rules – Temporary Period Spending Exception to Yield Restriction (Regulation 1.148-2)

The Final Regulations also expand the temporary period for working capital expenditures to apply to all working capital expenditures, not just working capital expenditures that are “restricted.” This expansion harmonizes the temporary period for any category of working capital expenditures with the safe-harbor against the creation of replacement proceeds for any category of working capital expenditures (discussed above). That is, if an issuer reasonably expects to spend proceeds of a bond issue on working capital expenditures within 13 months, and reasonably expects that the corresponding portion of the bond issue won’t be outstanding longer than 13 months, then the issuer can invest those proceeds for 13 months from the issue date at an unrestricted yield, and no “other replacement proceeds” will be deemed to arise. (4)

General Arbitrage Rebate Rules (Regulation 1.148-3)

Arbitrage rebate computation credit

The Final Regulations increase the credit against the payment of arbitrage rebate and add an inflation adjustment to the credit. (5)

Recovery of overpayment of rebate

Under the Prior Regulations, the amount of rebate that an issuer owes is based on the difference between the aggregate future value of all purchase prices of investments of bond proceeds and the aggregate future value of all receipts on investments of bond proceeds. However, for purposes of calculating a refund of an overpayment, issuers can only take into account the amount of rebate payments actually made (and not their future value). Commenters on the Proposed Regulations requested a change that would allow issuers to consider the future value of the amounts actually paid in calculating the amount of a refund of repaid rebate. In the preamble to the Final Regulations, Treasury indicated that if it permitted issuers to take into account the future value of rebate payments, it would be tantamount to paying issuers interest on the rebate overpayment. After concluding that neither Treasury nor the IRS has the statutory authority to pay interest on overpayments of arbitrage rebate, Treasury rejected the requested expansion of the overpayment calculation.

Bond Yield (Regulation 1.148-4)

Joint bond yield authority

Ignoring comments submitted by two commenters, the Final Regulations eliminate the ability to compute a single bond yield for two or more issues of qualified floating bonds or qualified student loan bonds. However, as discussed below, yield reduction payments are now available for qualified student loans and qualified mortgage loans generally. (6)

Modification of yield computation for yield-to-call premium bonds

The Final Regulations modify the yield calculations for certain callable bonds issued with more than a threshold amount of premium. Under the Prior Regulations, issuer had to treat these callable high-premium bonds as redeemed on the redemption date or maturity that would result in the lowest yield on the issue. The Final Regulations instead focus on the redemption date that results in the lowest yield on the particular bond. This change to the yield computation will require an amendment to many underwriter’s certificates following the Effective Date. (7)

Integration of hedges

The Final Regulations provide that a periodic payment on a hedge[3] includes a payment under a cost-of-funds swap, because the Final Regulations make clear that a “specified index” includes a cost-of-funds index. Therefore, a hedge that is based on an issuer’s cost of funds will not consist of a “significant investment element” and will thereby satisfy one of the requirements that a hedge must meet in order to be a qualified hedge.[4] (8)

Another element that must be satisfied for a hedge to be a qualified hedge is that the hedge must be interest based. The Final Regulations clarify both that a hedge based on a taxable index is an interest based contract and that the difference between the interest rate on the hedged bonds and the rate used to compute payments on the hedge will not preclude the hedge from being an interest based contract if those two rates are substantially similar. Practitioners had been concerned that payments under qualified hedges could not be based on taxable indices because interest rates on taxable indices do not correspond as closely as interest rates on tax-exempt indices. Furthermore, the Final Regulations permit the use of taxable indices without requiring the cumbersome correlation requirements proposed in the Proposed Regulations. (9)

The Final Regulations deviate from the Proposed Regulations by permitting “super integration”[5] (Treas. Reg. 1.148-4(h)(4)) of a taxable index hedge only when the variable rate on the hedged bonds and the variable rate on such a hedge are both based on a taxable index and are identical. The Treasury rejected comments requesting that super integration be permitted when both payments “nearly identical but not perfectly so.”

Finally, payments received by the issuer from the hedge provider will “closely correspond in time” (a requirement of integration) if the payments are made within 90 days of one another.

Identification of Qualified Hedges

Some of the more significant changes made by the Final Regulations relate to the identification of qualified hedges. One issuer-friendly provision extends the window of time during which the issuer can identify a hedge on its books and records so that the hedge will be a “qualified” hedge (assuming the other requirements in Treas. Reg. 1.148-4(h)(2) are met) from just 3 days under the Prior Regulations to 15 days. The Final Regulations further clarify that the period runs from the date that the parties enter into a binding agreement for the hedge (as opposed to the issue date of the hedged bonds).

Another provision from the Proposed Regulations that is retained in the Final Regulations is a requirement that hedge providers provide certain certifications about the hedge to the issuer in the form of a hedge provider certificate. Although the hedge provider certificate technically was not required under the Proposed Regulations, even commenters that opposed the requirement acknowledged that most issuers already use some form of provider’s certificate. In the preamble to the Final Regulations, the Treasury rightly said that the “hedge provider is uniquely positioned to validate pricing information needed to determine whether a hedge meets the requirements for being a qualified hedge.” (10)

Accounting for Modifications and Terminations

The provisions in the Final Regulations relating to the accounting for qualified hedges deviate substantially from the Prior Regulations.

As in the Prior Regulations, a qualified hedge will be deemed to be terminated if it is materially modified, if all or a portion of the hedged bonds are redeemed, or if the hedge ceases to meet the requirements to be a qualified hedge. However, the Final Regulations break from the Prior Regulations by providing that if the deemed termination would otherwise occur as a result of a material modification of the hedge or redemption of all or a portion of the hedged bonds, then the hedge will not be deemed to terminate if the hedge continues to meet the requirements of a qualified hedge. The Final Regulations contain a very similar rule that applies when hedged bonds are refunded but the hedge is not actually terminated. Importantly, both rules apply without regard to whether any portion of the hedge (that still meets the requirements to be a qualified hedge) is off-market as of the date of the modification or refunding. Accordingly, it is no longer necessary to identify the “on-market” portion and the “off-market” portion of a qualified hedge in a tax certificate or identification. Furthermore, if the re-integrated swap is actually terminated at a later date (e.g., if the hedged bonds are refunded using fixed rate bonds), 100% of the termination payment should be eligible to be financed with tax-exempt bond proceeds pursuant to the de minimis working capital exception in Treas. Reg. 1.148-6(d)(3)(ii)(2).

The Final Regulations provide that in the foregoing instances where the modification of the hedge or refunding of the hedged bonds does not trigger a deemed termination of the hedge, the hedge must be re-identified by the issuer of the bonds as a hedge of those bonds. The time period for the hedge to be re-identified begins on the date of the modification or the refunding, but the requirement for a hedge provider’s certificate is eliminated. (11)

To the extent that a qualified hedge terminates or is deemed to terminate, the Final Regulations modify the amounts taken into account as a payment made or received on the hedged bonds (which affects the yield on the hedged bonds). The Proposed Regulations proposed two separate rules to determine the amount of any payment taken into consideration based on whether the hedge was actually terminated or deemed to be terminated. The Final Regulations eliminate this distinction and provide a uniform fair market value standard for both actual and deemed terminations. The Treasury Department and the IRS rejected suggestions by commenters that amounts reflect the “bid side” of the hedge market. Instead, the Final Regulations indicate that the amounts taken into consideration are equal to the fair market value of the qualified hedge upon termination based on all of the facts and circumstances.

Yield and Valuation of Investments (Regulation 1.148-5)

Yield reduction payment rules

Under the Prior Regulations (and the Final Regulations), the arbitrage yield restriction rules govern when an issuer is permitted to earn a yield on the investment of bond proceeds that is materially higher than the yield of the bond issue. A rebate payment technically cannot cure violations of these rules, but the nearly identical yield reduction payment rules can. The Final Regulations expand the currently limited circumstances under which an issuer can make a yield reduction payment to cure violations of the yield restriction rules. This is perhaps the most significant change in the Final Regulations – the expansion of “covered investments” the yield of which can be reduced by making yield reduction payments.

The changes made by the Final Regulations to the definition of “covered investments” are comprehensive but two changes are particularly noteworthy. First, if Treasury has suspended the sale of Treasury Securities – State and Local Government Securities (“SLGS”), then an issuer can make yield reduction payments to reduce the yield of alternative nonpurpose investments even if the issuer purchased the investments with proceeds of an advance refunding issue. Second, in connection with the elimination of the joint bond yield authority for qualified student loan bonds and qualified mortgage bonds under the Prior Regulations (discussed above), issuers can now make yield reduction payments to reduce the yield on purpose investments allocable to all qualified student loans (not just those under the Federal Family Education Loan Program, which was terminated in by the Health Care and Education Reconciliation Act of 2010) and qualified mortgage loans. (12)

Valuation of investments

The Final Regulations clarify some ambiguity in the Prior Regulations and the Proposed Regulations regarding when investments (including a payment or receipt on the investment) should be valued based on present value or fair market value. Generally, issuers must value investments at their fair market value on the date the investment is first allocated to an issue or first ceases to be allocated to an issue. An exception to fair market valuation in the Prior Regulations applies when an investment is allocated from one issue of tax-exempt bonds to another issue of tax-exempt bonds as a result of the transferred proceeds or universal cap rules. The exception is a disincentive for issuers to refund tax-exempt bonds with taxable bonds, because in that situation the exception would not apply. Accordingly, the Final Regulations make clear that only the issue from which the investment is allocated needs to be tax-exempt.

Purpose investments are distinguished from nonpurpose investments in the Final Regulations. Purpose investments, along with yield restricted investments, must be valued at present value. (13)

Fair market value of Treasury obligations

Under the Prior Regulations, an issuer can treat the purchase price as the fair market value of an investment of bond proceeds in Treasury obligations (including SLGS) purchased on their original purchase date directly from the Treasury. However, there is some ambiguity for Treasury obligations that the issuer purchases on the open market. The Final Regulations clarify this ambiguity by specifying that, on any date other than the original purchase date, the fair market value of a SLGS security is its redemption price. The fair market value of Treasury obligations, other than SLGS, on any date other than the original purchase date remains subject to the general “arm’s-length” definition of fair market value. (14)

Modified fair market value safe harbor for guaranteed investment contracts

The Final Regulations clarify that, for purposes of meeting the safe harbor for establishing fair market value for guaranteed investment contracts, bid specifications will be “in writing and timely forwarded to potential providers” if they are made available to potential bidders on an internet website or other similar electronic media that is regularly used to post bid specifications. Furthermore, the Final Regulations clarify that a “writing” includes hard copy, fax, or e-mail. These provisions are unlikely to affect many financings because, in practice, bid specifications are always submitted via fax or electronic e-mail.

Another proposal from the Proposed Regulations that was adopted by the Final Regulations is that the “no last look” rule will not be violated by a potential provider reviewing other bids, so long as all potential providers have an equal opportunity to review all other bids.

External comingled investment fund

The Prior Regulations define “widely held comingled funds” to include a fund that has a daily average of more than 15 unrelated investors and the daily average amount each investor has invested is not less than the lesser of $500,000 or 1% of the daily average of the total amount held in the fund. This definition is peculiar because it precludes participation in the fund by smaller investors since all investors must maintain the minimum investment. The Final Regulations remedy this peculiarity by providing that as long as at 16 of the unrelated investors maintains a minimum level of investment, an unlimited number of smaller investors are also permitted to participate in the fund.

Other Provisions

Small Issuer Exception to Rebate Requirement – Pooled Bonds (Regulation 1.148-8)

The provision in the Prior Regulations that permits a pool bond issuer to ignore its pool bond issue in computing whether it has exceeded its $5 million limit for purposes of the small issuer rebate exception is eliminated in the Final Regulations. Effectively, however, the provision was eliminated in 2005 when the Tax Increase Prevention and Reconciliation Act of 2005 amended Section 148(f)(4)(D)(ii) to delete a similar provision.[6]

Anti-Abuse Rules and Authority of Commissioner (Regulation 1.148-10)

According to the arbitrage anti-abuse rules in the Prior Regulations, the Commissioner is permitted to deviate from the Final Regulations in the event that a principal purpose for entering into a transaction is to exploit the difference between tax-exempt and taxable interest rates in a manner inconsistent with the purposes of Section 148. If, at the discretion of the Commissioner, a transaction is inconsistent with the purposes of Section 148, the Commissioner can depart from the Final Regulations as “necessary to clearly reflect the economic substance of the transaction.” To avoid confusion of the Commissioner’s authority under the arbitrage anti-abuse rule with the economic substance doctrine under general tax principles, the Final Regulations amend the language in the Prior Regulations to permit the Commissioner to deviate from the Final Regulations “as necessary to reflect the economics of the transaction to prevent such financial advantage.”

Transition Provision for Certain Guarantee Funds (Regulation 1.148-11)

The Prior Regulations contain a transition rule against the creation of replacement proceeds for certain State funds that guarantee tax-exempt bond issues. The Final Regulations increase the amount of tax-exempt bonds that such State funds can guarantee without creating replacement proceeds. In addition, the Final Regulations permit the funds to guarantee certain issues of qualified 501(c)(3) bonds provided the proceeds are used to finance construction of charter schools or other “designated functions.” Under the Prior Regulations, the funds cannot guarantee any issue of private activity bonds.

Definitions (Regulation 1.150-1)

Definition of tax-advantaged bonds

The Final Regulations include the following definition of tax-advantaged bonds, which is consistent with the term that the IRS and bond lawyers have been using since the advent of tax-credit bonds:

Tax-advantaged bond means a tax-exempt bond, a taxable bond that provides a federal tax credit to the investor with respect to the issuer’s borrowing costs, a taxable bond that provides a refundable federal tax credit payable directly to the issuer of the bond for its borrowing costs under section 6431, or any future similar bond that provides a federal tax benefit[7] that reduces an issuer’s borrowing costs. Examples of tax-advantaged bonds include qualified tax credit bonds under section 54A(d)(1) and build America bonds under section 54AA.

Definition of issue

The Final Regulations clarify that taxable tax-advantaged bonds and other taxable bonds constitute separate issues of obligations and that different types of tax-advantaged bonds also constitute separate issues of obligations.

Definition and treatment of grants

The Final Regulations adopt without change the provisions in the Proposed Regulations regarding the treatment of grants. Therefore, the character and nature of a grantee’s use of proceeds is generally taken into account in determining whether arbitrage and other applicable requirements of the issue are met (i.e., the “look through” rule). Except on the rare occasion where there are private payments associated with proceeds that are granted to an unrelated party, private business use of tax-exempt bond proceeds that are granted to an unrelated party is not generally a concern. However, the impact that the look-through rule has on the calculation of the 120% limitation in Treas. Reg. 1.148-10(a)(4), Treas. Reg. 1.148-1(c)(4), and Section 147(b) of the Code could be significant. The look-through rule continues not to apply for purposes of determining whether proceeds of a bond issue are spent under Treas. Reg. 1.148-6(d)(4). (15)

Allocation and Accounting Regulations – Transition Rule

A transition rule is provided in the Final Regulations whereby certain provisions in the Allocation and Accounting Regulations promulgated in October of 2015 do not apply to a refunding issue provided the refunded bonds were issued prior to the effective date of the Allocation and Accounting Regulations and provided the weighted average maturity of the refunding bonds is no longer than that of the refunded bonds.

Revenue Procedure 97-15 – Revoked

The last and, quite frankly, least important provision in the Final Regulations is the random declaration that Revenue Procedure 97-15 is obsolete. If an issue of bonds ceases to meet certain requirements relating to the use of proceeds of that issue, Revenue Procedure 97-15 establishes a closing agreement program under which an issuer could request a closing agreement to prevent the interest on those bonds from being includible in gross income of the bondholders. IRS Notice 2008-31 includes a similar but more expansive closing agreement program so Revenue Procedure 97-15 is obsolete.

Exhibit

Reference Number	Citation	Prior Regulations	Final Regulations
(1)	Treas. Reg. 1.148-1(c)(4)(i)(B)(1)	(1) For the portion of an issue that is to be used to finance restricted working capital expenditures, if that portion is not outstanding longer than 2 years;	(1) For the portion of an issue that is to be used to finance working capital expenditures, if that portion is not outstanding longer than the temporary period under §1.148-2(e)(3) for which the proceeds qualify;
(2)	Treas. Reg. 1.148-1(c)(4)(i)(B)(4)	None	(4) For the portion of an issue (including a refunding issue) that is to be used to finance working capital expenditures, if that portion satisfies paragraph (c)(4)(ii) of this section. (ii) Safe harbor for longer-term working capital financings. A portion of an issue used to finance working capital expenditures satisfies this paragraph (c)(4)(ii) if the issuer meets the requirements of paragraphs (c)(4)(ii)(A) through (E) of this section. (A) Determine first testing year. On the issue date, the issuer must determine the first fiscal year following the applicable temporary period under §1.148-2(e) in which it reasonably expects to have available amounts (first testing year), but in no event can the first day of the first testing year be later than five years after the issue date. (B) Application of available amount to reduce burden on tax-exempt bond market. Beginning with the first testing year and for each subsequent fiscal year for which the portion of the issue that is the subject of this safe harbor remains outstanding, the issuer must determine the available amount as of the first day of each fiscal year. Then, except as provided in paragraph (c)(4)(ii)(D) of this section, within the first 90 days of that fiscal year, the issuer must apply that amount (or if less, the available amount on the date of the required redemption or investment) to redeem or to invest in eligible tax-exempt bonds (as defined in paragraph (c)(4)(ii)(E) of this section). For this purpose, available amounts in a bona fide debt service fund are not treated as available amounts. (C) Continuous investment requirement. Except as provided in this paragraph (c)(4)(ii)(C), any amounts invested in eligible tax-exempt bonds under paragraph (c)(4)(ii)(B) of this section must be invested continuously in such tax exempt bonds to the extent provided in paragraph (c)(4)(ii)(D) of this section. (1) Exception for reinvestment period. Amounts previously invested in eligible tax-exempt bonds under paragraph (c)(4)(ii)(B) of this section that are held for not more than 30 days in a fiscal year pending reinvestment in eligible tax-exempt bonds are treated as invested in eligible tax-exempt bonds. (2) Limited use of invested amounts. An issuer may spend amounts previously invested in eligible tax-exempt bonds under paragraph (c)(4)(ii)(B) of this section within 30 days of the date on which they cease to be so invested to make expenditures for a governmental purpose on any date on which the issuer has no other available amounts for such purpose, or to redeem eligible tax exempt bonds. (D) Cap on applied or invested amounts. The maximum amount that an issuer is required to apply under paragraph (c)(4)(ii)(B) of this section or to invest continuously under paragraph (c)(4)(ii)(C) of this section with respect to the portion of an issue that is the subject of this safe harbor is the outstanding principal amount of such portion. For purposes of this cap, an issuer receives credit towards its requirement to invest available amounts in eligible tax-exempt bonds for amounts previously invested under paragraph (c)(4)(ii)(B) of this section that remain continuously invested under paragraph (c)(4)(ii)(C) of this section. (E) Definition of eligible tax-exempt bonds. For purposes of paragraph (c)(4)(ii) of this section, eligible tax-exempt bonds means any of the following: (1) A bond the interest on which is excludable from gross income under section 103 and that is not a specified private activity bond (as defined in section 57(a)(5)(C)) subject to the alternative minimum tax; (2) An interest in a regulated investment company to the extent that at least 95 percent of the income to the holder of the interest is interest on a bond that is excludable from gross income under section 103 and that is not interest on a specified private activity bond (as defined in section 57(a)(5)(C)) subject to the alternative minimum tax; or (3) A certificate of indebtedness issued by the United States Treasury pursuant to the Demand Deposit State and Local Government Series program described in 31 CFR part 344.
(3)	Treas. Reg. 1.148-6(d)(3)(iii)(A)	(A) ***Except as otherwise provided, available amount excludes proceeds of the issue but includes cash, investments, and other amounts held in accounts or otherwise by the issuer or a related party if those amounts may be used by the issuer for working capital expenditures of the type being financed by an issue without legislative or judicial action and without a legislative, judicial, or contractual requirement that those amounts be reimbursed.	(A) ***Except as otherwise provided, available amount excludes proceeds of any issue but includes cash, investments, and other amounts held in accounts or otherwise by the issuer or a related party if those amounts may be used by the issuer for working capital expenditures of the type being financed by an issue without legislative or judicial action and without a legislative, judicial, or contractual requirement that those amounts be reimbursed.
(4)	Treas. Reg. 1.148-2(e)(3)	(3) Temporary period for restricted working capital expenditures—(i) General rule. The proceeds of an issue that are reasonably expected to be allocated to restricted working capital expenditures within 13 months after the issue date qualify for a temporary period of 13 months beginning on the issue date. Paragraph (e)(2) of this section contains additional temporary period rules for certain working capital expenditures that are treated as part of a capital project.	(3) Temporary period for working capital expenditures–(i) General rule. The proceeds of an issue that are reasonably expected to be allocated to working capital expenditures within 13 months after the issue date qualify for a temporary period of 13 months beginning on the issue date. Paragraph (e)(2) of this section contains additional temporary period rules for certain working capital expenditures that are treated as part of a capital project.
(5)	Treas. Reg. 1.148-3(d)(1)(iv)	(iv) On the last day of each bond year during which there are amounts allocated to gross proceeds of an issue that are subject to the rebate requirement, and on the final maturity date, a computation credit of $1,000;	(iv) On the last day of each bond year during which there are amounts allocated to gross proceeds of an issue that are subject to the rebate requirement, and on the final maturity date, a computation credit of $1,400 for any bond year ending in 2007 and, for bond years ending after 2007, a computation credit in the amount determined under paragraph (d)(4) of this section;
(5)	Treas. Reg. 1.148-3(d)(4)	None	(4) Cost-of-living adjustment. For any calendar year after 2007, the $1,400 computation credit set forth in paragraph (d)(1)(iv) of this section shall be increased by an amount equal to such dollar amount multiplied by the cost-ofliving adjustment determined under section 1(f)(3) for such year, as modified by this paragraph (d)(4). In applying section 1(f)(3) to determine this cost-of-living adjustment, the reference to “calendar year 1992” in section 1(f)(3)(B) shall be changed to “calendar year 2006.” If any such increase determined under this paragraph (d)(4) is not a multiple of $10, such increase shall be rounded to the nearest multiple thereof.
(6)	Treas. Reg. 1.148-4(a)	(a) *** The yield on an issue that would be a purpose investment (absent section 148(b)(3)(A)) is equal to the yield on the conduit financing issue that financed that purpose investment. The Commissioner may permit issuers of qualified mortgage bonds or qualified student loan bonds to use a single yield for two or more issues.	(a) *** The yield on an issue that would be a purpose investment (absent section 148(b)(3)(A)) is equal to the yield on the conduit financing issue that financed that purpose investment.
(7)	Treas. Reg. 1.148-4(b)(3)	(3) Yield on certain fixed yield bonds subject to optional early redemption—(i) In general. If a fixed yield bond is subject to optional early redemption and is described in paragraph (b)(3)(ii) of this section, the yield on the issue containing the bond is computed by treating the bond as redeemed at its stated redemption price on the optional redemption date that would produce the lowest yield on the issue.	(3) Yield on certain fixed yield bonds subject to optional early redemption– (i) In general. If a fixed yield bond is subject to optional early redemption and is described in paragraph (b)(3)(ii) of this section, the yield on the issue containing the bond is computed by treating the bond as redeemed at its stated redemption price on the optional redemption date that would produce the lowest yield on that bond.
(8)	Treas. Reg. 1.148-4(h)(2)(ii)(A)	(A)***.	(A) * * * Solely for purposes of determining if a hedge is a qualified hedge under this section, payments that an issuer receives pursuant to the terms of a hedge that are equal to the issuer’s cost of funds are treated as periodic payments under §1.446-3 without regard to whether the payments are calculated by reference to a “specified index” described in §1.446-3(c)(2). Accordingly, a hedge does not have a significant investment element under this paragraph (h)(2)(ii)(A) solely because an issuer receives payments pursuant to the terms of a hedge that are computed to be equal to the issuer’s cost of funds, such as the issuer’s actual market-based tax-exempt variable interest rate on its bonds.
(9)	Treas. Reg. 1.148-4(h)(2)(v)	(v) Interest-based contract and size and scope of hedge. The contract is primarily interest-based. A contract is not primarily interest based unless —	(v) Interest-based contract and size and scope of hedge. The contract is primarily interest-based (for example, a hedge based on a debt index, including a tax-exempt debt index or a taxable debt index, rather than an equity index). In addition, the size and scope^[8] of the hedge under the contract is limited to that which is reasonably necessary to hedge the issuer’s risk with respect to interest rate changes on the hedged bonds. For example, a contract is limited to hedging an issuer’s risk with respect to interest rate changes on the hedged bonds if the hedge is based on the principal amount and the reasonably expected interest payments of the hedged bonds. For anticipatory hedges under paragraph (h)(5) of this section, the size and scope limitation applies based on the reasonably expected terms of the hedged bonds to be issued. A contract is not primarily interest based unless–
(10)	Treas. Reg. 1.148-4(h)(2)(viii)(B)	None	(B) Hedge provider’s certification. The hedge provider’s certification must— (1) Provide that the terms of the hedge were agreed to between a willing buyer and willing seller in a bona fide, arm’s-length transaction; (2) Provide that the hedge provider has not made, and does not expect to make, any payment to any third party for the benefit of the issuer in connection with the hedge, except for any such third-party payment that the hedge provider expressly identifies in the documents for the hedge; (3) Provide that the amounts payable to the hedge provider pursuant to the hedge do not include any payments for underwriting or other services unrelated to the hedge provider’s obligations under the hedge, except for any such payment that the hedge provider expressly identifies in the documents for the hedge; and (4) Contain any other statements that the Commissioner may provide in guidance published in the Internal Revenue Bulletin. See §601.601(d)(2)(ii) of this chapter.
(11)	Treas. Reg. 1.148-4(h)(3)(iv)(C)	(C) Special rule for terminations when bonds are redeemed. Except as otherwise provided in this paragraph (h)(3)(iv)(C) and in paragraph (h)(3)(iv)(D) of this section, when a qualified hedge is deemed terminated because the hedged bonds are redeemed, the fair market value of the qualified hedge on the redemption date is treated as a termination payment made or received on that date. When hedged bonds are redeemed, any payment received by the issuer on termination of a hedge, including a termination payment or a deemed termination payment, reduces, but not below zero, the interest payments made by the issuer on the hedged bonds in the computation period ending on the termination date. The remainder of the payment, if any, is reasonably allocated over the bond years in the immediately preceding computation period or periods to the extent necessary to eliminate the excess. (D) Special rules for refundings. To the extent that the hedged bonds are redeemed using the proceeds of a refunding issue, the termination payment is accounted for under paragraph (h)(3)(iv)(B) of this section by treating it as a payment on the refunding issue, rather than the hedged bonds. In addition, to the extent that the refunding issue is redeemed during the period to which the termination payment has been allocated to that issue, paragraph (h)(3)(iv)(C) of this section applies to the termination payment by treating it as a payment on the redeemed refunding issue.	(C) Special rules for certain modifications when the hedge remains qualified. A modification of a qualified hedge that otherwise would result in a deemed termination under paragraph (h)(3)(iv)(B) of this section does not result in such a termination if the modified hedge is re-tested for qualification as a qualified hedge as of the date of the modification, the modified hedge meets the requirements for a qualified hedge as of such date, and the modified hedge is treated as a qualified hedge prospectively in determining the yield on the hedged bonds. For purposes of this paragraph (h)(3)(iv)(C), when determining whether the modified hedge is qualified, the fact that the existing qualified hedge is off-market as of the date of the modification is disregarded and the identification requirement in paragraph (h)(2)(viii) of this section applies by measuring the time period for identification from the date of the modification and without regard to the requirement for a hedge provider’s certification. (D) Continuations of certain qualified hedges in refundings. If hedged bonds are redeemed using proceeds of a refunding issue, the qualified hedge for the refunded bonds is not actually terminated, and the hedge meets the requirements for a qualified hedge for the refunding bonds as of the issue date of the refunding bonds, then no termination of the hedge occurs and the hedge instead is treated as a qualified hedge for the refunding bonds. For purposes of this paragraph (h)(3)(iv)(D), when determining whether the hedge is a qualified hedge for the refunding bonds, the fact that the hedge is off-market with respect to the refunding bonds as of the issue date of the refunding bonds is disregarded and the identification requirement in paragraph (h)(2)(viii) of this section applies by measuring the time period for identification from the issue date of the refunding bonds and without regard to the requirement for a hedge provider’s certification.
(12)	Treas. Reg. 1.148-5(c)	(c) Yield reduction payments to the United States -(1) In general. In determining the yield on an investment to which this paragraph (c) applies, any amount paid to the United States in accordance with this paragraph (c), including a rebate amount, is treated as a payment for that investment that reduces the yield on that investment. (3) Applicability of special yield reduction rule – (i) Covered investments. This paragraph (c) applies to – (D) Purpose investments allocable to qualified student loans under a program described in section 144(b)(1)(A);	(c) Yield reduction payments to the United States—(1) In general. In determining the yield on an investment to which this paragraph (c) applies, any amount paid to the United States in accordance with this paragraph (c), including a rebate amount, is treated as a payment for that investment that reduces the yield on that investment. (3) Applicability of special yield reduction rule. Paragraph (c) applies only to investments that are described in at least one of paragraphs (c)(3)(i) through (ix) of this section and, except as otherwise expressly provided in paragraphs (c)(3)(i) through (ix) of this section, that are allocated to proceeds of an issue other than gross proceeds of an advance refunding issue. (iv) Purpose investments allocable to qualified student loans and qualified mortgage loans. Purpose investments allocable to qualified student loans and qualified mortgage loans. (viii) Nonpurpose investments allocable to proceeds when State and Local Government Series Securities are unavailable. Nonpurpose investments allocable to proceeds of an issue, including an advance refunding issue, that an issuer purchases if, on the date the issuer enters into the agreement to purchase such investments, the issuer is unable to subscribe for State and Local Government Series Securities because the U.S. Department of the Treasury, Bureau of the Fiscal Service, has suspended sales of those securities.
(13)	Treas. Reg. 1.148-5(d)	(d) Value of investments -(1) In general. Except as otherwise provided, the value of an investment (including a payment or receipt on the investment) on a date must be determined using one of the following valuation methods consistently for all purposes of section 148 to that investment on that date: (i) Plain par investment – outstanding principal amount. A plain par investment may be valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date. (ii) Fixed rate investment – present value. A fixed rate investment may be valued at its present value on that date. (iii) Any investment – fair market value. An investment may be valued at its fair market value on that date. (2) Mandatory valuation of yield restricted investments at present value. Any yield restricted investment must be valued at present value. For example, a purpose investment or an investment allocable to gross proceeds in a refunding escrow after the expiration of the initial temporary period must be valued at present value. See, however, paragraph (b)(3) of this section. (3) Mandatory valuation of certain investments at fair market value – (i) In general. Except as provided in paragraphs (d)(2), (d)(3)(ii), and (d)(4) of this section, an investment must be valued at fair market value on the date that it is first allocated to an issue or first ceases to be allocated to an issue as a consequence of a deemed acquisition or deemed disposition. For example, if an issuer deposits existing investments into a sinking fund for an issue, those investments must be valued at fair market value as of the date first deposited into the fund. (ii) Exception to fair market value requirement for transferred proceeds allocations, universal cap allocations, and commingled funds. Paragraph (d)(3)(i) of this section does not apply if the investment is allocated from one issue to another issue as a result of the transferred proceeds allocation rule under § 1.148-9(b) or the universal cap rule under § 1.148-6(b)(2), provided that both issues consist exclusively of tax-exempt bonds. In addition, paragraph (d)(3)(i) of this section does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is an investment being initially deposited in or withdrawn from a commingled fund described in § 1.148-6(e)(5)(iii).	(d) Value of investments—(1) In general. Except as otherwise provided, the value of an investment (including a payment or receipt on the investment) on a date must be determined using one of the following valuation methods consistently for all purposes of section 148 to that investment on that date: (i) Plain par investment—outstanding principal amount. A plain par investment may be valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date. (ii) Fixed rate investment—present value. A fixed rate investment may be valued at its present value on that date. (iii) Any investment—fair market value. An investment may be valued at its fair market value on that date. (2) Mandatory valuation of certain yield restricted investments at present value. A purpose investment must be valued at present value, and except as otherwise provided in paragraphs (b)(3) and (d)(3) of this section, a yield restricted nonpurpose investment must be valued at present value. (3) Mandatory valuation of certain investments at fair market value—(i) In general. Except as otherwise provided in paragraphs (d)(3)(ii) and (d)(4) of this section, a nonpurpose investment must be valued at fair market value on the date that it is first allocated to an issue or first ceases to be allocated to an issue as a consequence of a deemed acquisition or deemed disposition. For example, if an issuer deposits existing nonpurpose investments into a sinking fund for an issue, those investments must be valued at fair market value as of the date first deposited into the fund. (ii) Exception to fair market value requirement for transferred proceeds allocations, certain universal cap allocations, and commingled funds. Paragraph (d)(3)(i) of this section does not apply if the investment is allocated from one issue to another as a result of the transferred proceeds allocation rule under §1.148-9(b) or is deallocated from one issue as a result of the universal cap rule under §1.148-6(b)(2) and reallocated to another issue as a result of a preexisting pledge of the investment to secure that other issue, provided that, in either circumstance (that is, transferred proceeds allocations or universal cap deallocations), the issue from which the investment is allocated (that is, the first issue in an allocation from one issue to another issue) consists of tax-exempt bonds. In addition, paragraph (d)(3)(i) of this section does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is an investment being initially deposited in or withdrawn from a commingled fund described in §1.148-6(e)(5)(iii).
(14)	Treas. Reg. 1.148-5(d)(6)	(6) Definition of fair market value – (i) In general. *** The fair market value of a United States Treasury obligation that is purchased directly from the United States Treasury is its purchase price.	(6) Definition of fair market value—(i) In general. *** On the purchase date, the fair market value of a United States Treasury obligation that is purchased directly from the United States Treasury, including a State and Local Government Series Security, is its purchase price. The fair market value of a State and Local Government Series Security on any date other than the purchase date is the redemption price for redemption on that date.
(15)	Treas. Reg. 1.150-1(f)	None	(f) Definition and treatment of grants—(1) Definition. Grant means a transfer for a governmental purpose of money or property to a transferee that is not a related party to or an agent of the transferor. The transfer must not impose any obligation or condition to directly or indirectly repay any amount to the transferor or a related party. Obligations or conditions intended solely to assure expenditure of the transferred moneys in accordance with the governmental purpose of the transfer do not prevent a transfer from being a grant. (2) Treatment. Except as otherwise provided (for example, §1.148-6(d)(4), which treats proceeds used for grants as spent for arbitrage purposes when the grant is made), the character and nature of a grantee’s use of proceeds are taken into account in determining which rules are applicable to the bond issue and whether the applicable requirements for the bond issue are met. For example, a grantee’s use of proceeds generally determines whether the proceeds are used for capital projects or working capital expenditures under section 148 and whether the qualified purposes for the specific type of bond issue are met.
(15)	Treas. Reg. 1.150-2(d)(3)	(3) Nature of expenditure. The original expenditure is a capital expenditure, a cost of issuance for a bond, an expenditure described in § 1.148-6(d)(3)(ii)(B) (relating to certain extraordinary working capital items), a grant (as defined in § 1.148-6(d)(4)), a qualified student loan, a qualified mortgage loan, or a qualified veterans’ mortgage loan.	(3) Nature of expenditure. The original expenditure is a capital expenditure, a cost of issuance for a bond, an expenditure described in §1.148-6(d)(3)(ii)(B) (relating to certain extraordinary working capital items), a grant (as defined in §1.150-1(f)), a qualified student loan, a qualified mortgage loan, or a qualified veterans’ mortgage loan.

[1] The numbers in parenthesis relate to the provisions from the Prior and Final Regulations on the exhibit at the end of this blog.

[2] For this purpose, “eligible tax-exempt bonds” means: (1) a tax-exempt bond the interest on which is not subject to the alternative minimum tax; (2) demand deposit United States Treasury Obligations – State and Local Government Series; and (3) interests in a regulated investment company where at least 95% of the income to the holder of the interest in the RIC is derived from tax-exempt bonds, the interest on which is not subject to the alternative minimum tax.

[3] Discussed in Treas. Reg. 1.148-4(h)(2)(ii)(A).

[4] Payments made or received in respect of a qualified hedge are taken into account in determining the yield of the tax-exempt bond issue, and the cost of a qualified hedge for such an issue can be financed with proceeds of the issue.

[5] Super integration of a hedge with a variable rate tax-exempt bond results in the bond being treated as a fixed yield bond for federal tax purposes.

[6] Section 508 of the Tax Increase Prevention and Reconciliation Act of 2005 deleted subclause II in Section 148(f)(4)(D)(ii) which read “all bonds issued by a governmental unit to make loans to other governmental units with general taxing powers not subordinate to such unit shall, for purposes of applying such subclause to such unit, be treated as not issued by such unit.”

[7] The definition in the Final Regulations is identical to the definition in the Proposed Regulations except the Proposed Regulations referred to a “federal subsidy” which was changed in the revised definition to “federal tax benefit.” No explanation is given in the preamble for this change.

[8] The “size and scope” limitation was included in the Proposed Regulations and is intended to clarify that certain leveraged hedges are not qualified hedges.