When does 10% PBU really mean 5% PBU?

When the Internal Revenue Code (“IRC”) says it does.  (For those of you that want to remind yourselves of how a bill becomes a law, such as the IRC, see this video from Schoolhouse Rock).        

As you may know, issuers of governmental-use bonds are generally permitted to use up to 10% of the tax-exempt bond proceeds of an issue for private business use (“PBU”) before the tax-exempt bonds run the risk of being characterized as taxable private-activity bonds (“PABs”).  If the PBU exceeds 10%, then the issuer will also need to determine whether the private security or payment (“Private Payment”) test is met in order to determine if the bonds are PABs.  (Remember, meeting the 10% PBU and  Private Payment tests is generally a bad thing).  However, because nothing is simple in the tax world, there is a second PBU/Private Payment threshold that you may not be as familiar with – the 5% unrelated or disproportionate test.[1]    

The first step in applying the 5% unrelated/disproportionate test is to determine if the identified PBU is related to a governmental use.

What does “unrelated” (or “related”) mean in this context?  It depends.  The test is applied on a case-by-case basis, but the regulations identify some relevant factors.  For example, in general, PBU will only be considered related PBU if it is within or adjacent to the governmentally used facility.   By way of example, the legislative history to these provisions indicates that a privately operated cafeteria in a school building would be deemed related PBU, while a stand-alone administrative building for the private operator of all of a school system’s cafeterias would be unrelated PBU. [2]   Also, simultaneous use of a facility for the same purpose by a private party and governmental user (e.g., parking) will generally make the PBU related, as long as the simultaneous governmental use of such facility is “not insignificant.”  What does “not insignificant” mean?  Other than it logically means the government use is “significant,” your guess is as good as mine, as there does not appear to be any specific guidance providing insight (e.g., a percentage) in this regard.

If the PBU is unrelated to a governmental use, and exceeds the 5% threshold, the unrelated PBU test is met (a bad result).  If the PBU is related to the governmental use, then the issuer must determine if the related PBU is disproportionate to the governmental use.  

What does “disproportionate” mean in this context?  Excess. PBU is disproportionate to the related governmental use only to the extent that the amount of proceeds allocated to the related PBU exceeds the amount of proceeds allocated to the governmental use.  By way of example, an issuer issues $50 million of bonds with $46 million of proceeds used for construction of an administrative building and $500,000 of proceeds used for improvements to a courthouse, neither of which have any PBU.  The remaining $3.5 million of bond proceeds is spent on a private parking garage next to the courthouse.  In this hypothetical, the total PBU is 7%, which is less than the general 10% permitted PBU.  However, $3 million of the PBU bond proceeds would be characterized as disproportionate to the related governmental use ($3.5 million spent on the private parking garage next to the courthouse less the $500,000 spent on the courthouse).  Because this $3 million results in 6% of the proceeds being used in PBU that is related, but disproportionate to the governmental purposes of the bond issue ($3 million/$50 million), the disproportionate PBU test is met (a bad result).   

What happens if the 5% unrelated/disproportionate PBU test has been met?  Then the issuer must determine whether the 5% Private Payment portion of the unrelated/disproportionate test is met.  If it is, the issue will be deemed (taxable) PABs (unless a qualifying remedial action can be taken to avoid satisfaction of the 5% unrelated/disproportionate PBU threshold – a topic for another blog post). 

What is the Lesson Learned?  Given all the complexity that the 5% unrelated/disproportionate test adds to an already complex PBU and Private Payment landscape, it is too bad that the bill including these provisions did not die on Capitol Hill.


[1] The below discussion summarizes the provisions set forth in IRC Section 141(b)(3) and Reg. §1.141-9. 

[2] Conference Committee Report to P.L. 99-514 (1986), H.R. Conf. Rep. No. 99-841, II-691.

House Passes $78 Billion Tax Bill that Includes Affordable Housing Help

On Wednesday, January 31, 2024, the U.S. House of Representatives passed the bill called the Tax Relief for American Families and Workers Act.  Contained in this bill is a significant reduction to the required amount of Section 142(d) Qualified Residential Project Bonds that must be issued to obtain the 4% Low Income Housing Tax Credit.  The author of this blog post co-authored a blog post[1] with Robert Labes on this very topic! 

Click here to access the blog post and other insights regarding Global Projects and Infrastructure! And stay tuned for more on this and other developments in affordable and workforce housing tax issues in the coming weeks!


[1] Kind of like Russian nesting dolls.

Love Me Tender [Bonds] – An Overview

The famous song, Love Me Tender, by Elvis Presley, includes lyrics such as “We’ll never part” and about being together “ ’Til the end of time.”  In contrast to Elvis’ wish, the issuer of tax-exempt bonds that makes a tender offer is hoping the exact opposite happens to the relationship between the bondholder and tax-exempt bond.  In other words, the issuer hopes that economics drive a wedge between the two.

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Keep Your Paws Off My Positive Arbitrage – “With the Same Power Comes More Responsibility”

The time has come, friends. The Rebate Series ends with this post. At least for a little while. So far we’ve covered the basics of arbitrage and rebate and two key timing-based spending exceptions: the 6-Month Exception and the 18-Month Exception. This party bus now comes to a halt with the Two-Year Spending Exception, the last and longest of the timing-based exceptions to the rebate requirement. If you’ve made it this far, thank you. If this is your first rebate-related post, please read the previous posts setting the stage. 

Episode 3: Rebate & Arbitrage 101 – Two-Year Spending Exception

Like its name suggests, the Two-Year Spending Exception provides an exception to the rebate requirement for certain non-refunding issues when net proceeds of such bonds are spent within two years of the issue date of the bonds.  This exception is only available for: (1) governmental bonds, (2) qualified 501(c)(3) bonds, and (3) private activity bonds that finance property owned by a governmental unit or a 501(c)(3) organization.

Additionally, and unlike the 6- and 18-Month Exceptions, to qualify for the Two-Year Exception, an issuer must reasonably expect at least 75% of the “Available Construction Proceeds” of the issue will be used for construction expenditures. Construction expenditures are those capital expenditures allocable to the cost of real property or constructed personal property, which may include rehabilitation costs.  Available Construction Proceeds are defined as…

[issue price + investment earnings on entire issue price + earnings and investment earnings on any reasonably required reserve or replacement fund[1] – costs of issuance – amounts deposited in a reasonably required reserve or replacement fund]

Investment earnings include actual earnings up to the end of each 6-month spending period (shown below) and the reasonably expected earnings thereafter, unless the issuer elects on or before the issuance date to apply actual facts, rather than reasonable expectations, to ascertain the investment earnings. If the issuer does not make this election, the issuer must evaluate and reevaluate its earnings expectations every six months during the two-year construction period to recalculate the Available Construction Proceeds to ensure that the issue is still eligible for this exception to rebate.[2]  

Just like with the other two spending exceptions, there are certain spending benchmarks an issuer must hit to qualify for the Two-Year Spending Exception:

  • At least 10% of Available Construction Proceeds allocated to expenditures within 6 months after the issuance date;
  • At least 45% of Available Construction Proceeds allocated to expenditures within 12 months after the issuance date;  
  • At least 75% of Available Construction Proceeds allocated to expenditures within 18 months after the issuance date, and
  • 100% of Available Construction Proceeds allocated to expenditures within two years after the issuance date, subject to reasonable retainage and de minimis exceptions.

The reasonable retainage and de minimis exceptions, which were discussed in the previous post, allow an issuer to still qualify for the Two-Year Spending Exception if (1) unspent amounts retained for reasonable business purposes (think costs associated construction compliance or funds to cover potential construction-related disputes), not to exceed 5% of the Available Construction Proceeds, are spent within three years of the issue date and/or (2) proceeds equal to the lesser of 3% of Available Construction Proceeds or $250,000 (a so-called de minimis amount in the IRS’s eyes) remain unspent and the issue exercised due diligence to complete the project within the two-year time frame.


[1] These earnings are included in Available Construction Proceeds for the period from the issue date until the earlier of the date construction is substantially complete or two years from the issue date. On or before the issue date, an issuer may elect to exclude these earnings from being considered Available Construction Proceeds, which will then subject the earnings to rebate.

[2] To make things a little bit easier, issuers can use reasonably expected earnings as of the issue date to determine the Available Construction Proceeds for the first three semiannual spending periods.

Keep Your Paws Off My Positive Arbitrage – “With Great Power Comes Some Responsibility”

Our previous post kicked off our Rebate Series by introducing core concepts and terms. However, for every rule there is an exception. And, as you will learn shortly, for every exception there is an exception to that exception (except when there is not).

The next two episodes will focus on the so-called timing exceptions. In the rebate world, there are three: the 6-month, 18-month and two-year spending exceptions to the rebate requirement. Two general points to keep in mind: (1) each of these exceptions is independent of the others; so an issue could qualify under more than one, and (2) the spending exceptions are not automatically applied; so an issuer can choose NOT to apply them.

This post will cover the 6-month and 18-month spending exceptions, saving the best (or honestly, the most confusing) for last.

Episode 2: Rebate & Arbitrage 101 – 6-Month and 18-Month Spending Exceptions

Exceptions to the rebate requirement requiring an issuer to rebate unpermitted arbitrage to the federal government allow an issuer to keep all interest earnings that would otherwise be subject to rebate.

Why does the federal government allow this? The faster the bond proceeds are spent, the less likely issuers can earn arbitrage profits in the first place.  Also, the possibility of retaining arbitrage profits if bond proceeds are spent quickly enough serves as a positive incentive for the rapid expenditure of bond proceeds, an outcome the Treasury favors.   

6-Month Spending Exception

The rebate requirement will be considered satisfied, i.e., arbitrage earnings will not need to be rebated to the U.S. Treasury, if:

  1. All Gross Proceeds (defined in Episode 1), subject to some exceptions, are allocated to expenditures for the governmental purpose of the issue within 6 months from the issuance date of the bonds; and
  2. Earnings on amounts that are not required to be spent within the 6-month period (except on amounts in a qualifying bona fide debt service fund) are timely paid to the United States as rebate.

And here is an exception to the 6-month spending exception: the 6-month period is extended an additional 6 months if the unexpended Gross Proceeds at the end of the original 6-month period do not exceed 5% of the proceeds of the issue.

Refunding issues are eligible as well (and, in fact, are only eligible for the 6-month exception). If all Gross Proceeds of a refunding issue (other than Transferred Proceeds) are expended within 6 months after the date of issue, any arbitrage earnings will not need to be rebated. Transferred Proceeds of refunding  bonds remain subject to rebate unless a spending exception is satisfied, with the issuance date of the refunded bonds serving as the starting point for determining whether a spending exception is satisfied. 

18-Month Spending Exception

The 18-month spending exception, which is the only one of the three spending exceptions created by the Regulations and not the Code,[1] may be applied if:

  1. All Gross Proceeds, subject to some exceptions, are allocated to expenditures for the governmental purpose of the issue in accordance with the following schedule, each measured from the issuance date:
    1. At least 15% of Gross Proceeds allocated within 6 months;
    1. At least 60% of Gross Proceeds allocated within 12 months; and
    1. 100% within 18 months, subject to reasonable retainage and a de minimis exception (discussed below); and
  2. Earnings on amounts that are not required to be spent within the 18-month period (except on amounts in a qualifying bona fide debt service fund) are timely paid to the United States as rebate.

To determine compliance with the first two milestones—6 months and 12 months—the amount of Investment Proceeds included in Gross Proceeds is based on the issuer’s reasonable expectations on the date of issue.

Retainage is the portion of payment due that is temporarily retained by the issuer to ensure the contractor completes (or substantially completes) a project correctly. If reasonable[2] retainage is allocated to expenditures within 30 months of the issue date, the issue will not fail to satisfy the 18-month spending exception. Additionally, if a de minimis amount of proceeds—equal to the lesser of 3% of available proceeds or $250,000—is not allocated to expenditures within the required 18-month timeframe (or 30-month timeframe, if there’s reasonable retainage), the issuer may still meet the 18-month spending exception.  


[1] This solved a Goldilocks issue: the 6-month spending exception was too short and the two-year spending exception was too confusing and narrow to fit most transactions. The 18-month spending exception is therefore (now bear with me) jussstt righttt.

[2] Meaning not more than 5% of available proceeds are retained.

Keep Your Paws Off My Positive Arbitrage

Reader’s Note: As this is my first post on The Public Finance Tax Blog™ let me provide a necessary introduction. My name is Natalie, an associate with the Public Finance Tax Group here at Squire Patton Boggs. A little bit about me: I have the superhuman ability of not getting mosquito bites; I hate when people pronounce the “L” in salmon; and perhaps most relevant to you, if I can learn tax and finance concepts, so can you.

Additional Reader’s Note: This post has gone through several iterations already. Not because the information missed the mark (a junior associate’s worst nightmare, I promise you), but because I needed to “fun it up.” When tax lawyers call you boring, it may be time to rethink most if not all life decisions. Short of quitting my job, changing my name and generally falling off the face of the planet, I suppose I’ll start here. With this post. On Rebate. Naturally.

Episode 1: Rebate & Arbitrage 101 – Putting the Fun in Fundamentals

Because the fundamentals are the building blocks of fun, this post introduces the rebate requirement under Section 148 of the Internal Revenue Code and the key terms necessary for the episodes to come.

To understand rebate, you must understand arbitrage. And to understand arbitrage, well, you kind of just need to understand arbitrage. As discussed more thoroughly in a recent blog post, arbitrage occurs when securities purchased from one market are used for immediate resale in another to profit from the interest rate discrepancy. This is not a concept specific to tax-exempt or tax-advantaged bond financings, but the monitoring of arbitrage by the federal government occupies considerable space in our little corner of the public finance cosmos.

Let’s break down the rebate requirement into one confusing, soupy sentence:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage[1] from the investment of Gross Proceeds into Nonpurpose Investments must be rebated[2] to the U.S. Treasury if the earnings on those investments exceed the yield on the tax-exempt bonds (so-called Higher Yielding Investments).

This Rebate Amount is based on the difference between the amount actually earned on that investment and the amount that would have been earned if the investment had a yield equal to the yield on the issue. There are exceptions to this rebate requirement, which are the subject of our later episodes in this series.

Let’s unpack some of the key terms mentioned above:

Gross Proceeds in the tax-exempt bond space include (i) sale proceeds (amount paid for the bonds by the purchaser), (ii) investment proceeds (amounts received from the investment of proceeds), (iii) transferred proceeds (remaining proceeds of a prior issue when a refunding occurs), and (iv) replacement proceeds (amounts related enough to the issue or governmental purpose of the issue such that they could have been used for that purpose if the proceeds were not already).

A Nonpurpose Investment is any investment property that is acquired with the Gross Proceeds of an issue that is not acquired in order to carry out the governmental purpose of the issue. Investment property includes securities, obligations, annuity contracts and investment type property. Interestingly, investment property excludes tax-exempt bonds, so issuers may avoid rebate requirements by investing proceeds in those.

Higher Yielding Investments are investment property acquired with bond proceeds that produces a yield that exceeds the yield on the issue.

Now equipped with these handy definitions, let’s decipher our soupy sentence from above:

For an issuer of tax-exempt bonds, certain earnings resulting in positive arbitrage from the investment of [sale, investment, transferred and replacement proceeds, as applicable] into [investment property not used for the governmental purpose of the bonds] must be rebated to the U.S. Treasury if the earnings on [the investment of the bond proceeds produce an impermissibly higher yield on the issue].

The issue date of the bonds starts the clock for measuring arbitrage, using the bond yield as the arbitrage limit. Per the general rebate rules, every five years a calculation of the Rebate Amount must be made. Does the federal government really expect issuers to look into a crystal ball to determine potential arbitrage issues for bonds that mature in ten, twenty or thirty years? Well, sort of. An issuer must use its “reasonable expectations” at the time the bonds are issued in making arbitrage determinations. If there is a Rebate Amount, then such amount must be rebated to the federal government within sixty days of the computation date for that period. If the applicable amount is not rebated, the bonds will become “arbitrage bonds,” the interest on which is subject to federal income tax. 


[1] Negative arbitrage presents its own concerns, which are discussed in a previous blog. And yes, while that seminal piece of Public Finance blog canon is informative and helpful and you should absolutely read it, the best parts are the tags at the bottom. On the off chance you happen to Google “Portlandia public finance tax” (as any curious well-adjusted person might do), guess what comes up.  

[2] If you’re curious why the concept is called “rebate” when profits earned from arbitrage were never the federal government’s in the first place, check out one of our other blog posts. It does not have any fun tags. Sorry.

When Overburdening isn’t a Burden

Cindy Mog recently reacquainted us with abusive arbitrage devices, including the factors that evidence overburdening of the tax-exempt bond market (issuing bonds too early, issuing too many bonds, and issuing bonds with an excessive weighted average maturity) and factors that countervail what would otherwise constitute overburdening (bona fide cost underruns, bona fide need to finance extraordinary working capital items, and an issuer’s long-term financial distress).

The IRS released a timely private letter ruling (PLR 202309014) on March 3 that analyzes the foregoing factors. This private letter ruling deals with whether an issue of long-term working capital (re)financing bonds was subject to the proceeds-spent-last rule and whether the issue overburdened the tax-exempt bond market. The IRS concluded that the issue was not subject to the proceeds-spent-last rule and did not overburden the tax-exempt bond market, because the issue refinanced extraordinary, nonrecurring working capital expenditures that were not covered by insurance or a reserve fund.

Perhaps if Cindy writes a post on tax-exempt advance refunding bonds, Congress will enact a law that restores them.

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 3 – What Happens to the Arbitrage Sinners and the Arbitrage Saints?)

As you may remember, in Episode 1 we discussed some background regarding the prohibition against abusive arbitrage devices and the policy behind that prohibition – to encourage investment of tax-exempt bond proceeds in long-lived, tangible assets, while discouraging the generation of arbitrage on the investment of such proceeds.  In Episode 2 we discussed the three factors the federal government examines to determine whether an issuer has overburdened the tax-exempt bond market, which results in an abusive arbitrage device if the issuer has also successfully exploited the difference between taxable and tax-exempt interest rates.  In this episode, we will describe the penalties imposed upon rule-breakers and the rewards offered to rule-followers.

What happens if you have an abusive arbitrage device?  The tax-exempt bonds become taxable arbitrage bonds.   Thus, issuers of tax-exempt bonds will want to be mindful of the rules (i.e., the guardrails) set by the federal government to avoid an abusive arbitrage device.  A more fun way to think about it is that, given the serious consequences of straying off of the envisioned path, issuers will want to drive the old-fashioned cars at the amusement park that keep you on track, rather than the Dodgems. 

What happens if you follow the arbitrage rules?  The tax-exempt bonds will remain tax-exempt (assuming, of course, that all non-arbitrage rules governing tax-exempt bonds are followed).  As a bonus, the issuer may also qualify for an exception to rebate and be able to retain its positive arbitrage.  For a detailed description of the various spending exceptions to rebate, please tune in to our spin-off rebate miniseries which will be coming soon to the Public Finance Tax Blog. 

What is the moral of the arbitrage story for issuers?  Know the basic rules.  Reach out to your favorite tax-exempt bond lawyer at SPB to make sure you are complying with the finer points of the basic rules.  Invest and spend your tax-exempt bond proceeds wisely and efficiently while adhering to the rules, and you may end up with both tax-exempt bonds and arbitrage that you can keep. 

The end.

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 2 – Overburdening (Generally) Not Allowed)

As you may remember, in the first episode, we discussed how the federal government’s primary goal in subsidizing tax-exempt bonds is to encourage investment by issuers in long-lived, tangible assets. We also discussed how the federal government has tried to keep issuers on the intended path by preventing them from exploiting the difference between the tax-exempt and taxable markets. Finally, we noted that bonds will generally be taxable arbitrage bonds if the issuer has successfully exploited the difference between tax-exempt and taxable interest rates and has also overburdened the tax-exempt bond market.

This episode will discuss the three rules intended to prevent the overburdening of the tax-exempt bond market – (1) You shall not issue too early; (2) You shall not issue too much; and (3) You shall not issue for too long. 

Why would you issue too early?   To take advantage of a low interest rate environment.  For example, an issuer might not have a capital project for Year 1 when interest rates are low, but anticipates having a capital project in Year 3 when interest rates might be higher.  The rule imposed by the federal government to prevent the issuer from issuing tax-exempt bonds too early is a requirement that the issuer reasonably expect on the issuance date of the tax-exempt bonds that it will spend at least 85% of the spendable proceeds within three years of the issuance date.  Even though the test involves “reasonable expectations,” remember that hindsight is always 20/20, and thus issuers should strive to actually meet this goal.  

Why would you issue too much?  To take advantage of a low interest rate environment. If an issuer reasonably expects that the proceeds of its tax-exempt bond issue will exceed the governmental purpose of the issue by more than $100,000, that constitutes evidence that the issuer overburdened the tax-exempt bond market by issuing too many tax-exempt bonds. Thus, it is best to avoid having over $100,000 of unspent proceeds upon completion of the bond-financed project. Unexpected excess sale and investment proceeds of the tax-exempt bond issue can be used to redeem or defease bonds of the issue to comply with this $100,000 limitation on unspent proceeds.

Why would you issue for too long?  To take advantage of a low interest rate environment, and possibly for cash flow reasons (i.e., to defer principal payments).  If the weighted average maturity (WAM) of the bond issue exceeds 120% of the weighted average economic life of the assets financed by the bond issue, that is evidence that the issuer overburdened the tax-exempt bond market by letting its bonds remain outstanding too long.  In other words, the federal government does not want issuers issuing 30-year tax-exempt bonds to finance computers with a 5-year useful life (unless, of course, the amortization of the bonds is front-loaded, such that the WAM of the bond issue does not exceed 6 years).

When overburdening isn’t actually overburdening.  Even if an issuer satisfies one or more factors discussed above, the issuer’s action will be excused (meaning that no overburdening will be deemed to occur) if the issuer can demonstrate that the action was necessitated by factors such as unexpected construction delays, bona fide cost underruns, a bona fide need to finance extraordinary working capital expenditures (e.g., a litigation settlement), or the issuer’s long-term financial distress.  Exceptions.  They are what keep tax lawyers employed. 

Preview of Episode 3 – What Happens to the Arbitrage Sinners and the Arbitrage Saints?

Next week’s Season Finale will discuss what happens to issuers that violate the arbitrage rules, along with some potential rewards for the rule-followers.

Stay tuned . . .

Abusive Arbitrage Devices – It’s Time to Get Reacquainted

(Episode 1 – Background and Arbitrage Basics)

Sometimes it is a good exercise to remind ourselves of some basic rules governing tax-exempt bonds.  One such rule is that bonds are taxable arbitrage bonds if an “abusive arbitrage device” is used in connection with the bonds.  An abusive arbitrage device is any action that has the effect of: (1) enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to obtain a material financial advantage; and (2) overburdening the tax-exempt bond market.[1]  (Keep in mind that an “abusive arbitrage device” is only one specific type of “arbitrage bond.”  We chose to cover abusive arbitrage devices because they are of renewed relevance and they touch on many arbitrage concepts.)  The first element of an abusive arbitrage device has been difficult (to the point of impossibility) to satisfy since Mad Men first aired.[2]  However, the Federal Reserve’s hawkish monetary policy has now made it much easier to exploit the difference between tax-exempt and taxable interest rates.  Thus, it’s time to get reacquainted (or acquainted, depending on where you are in your career) with the concept of abusive arbitrage devices.  The Public Finance Tax Blog is here to help, with a three-part mini-series of posts on this topic.

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