On June 24, 2015, the United States Department of the Treasury withdrew controversial proposed regulations from 2013 (the “Withdrawn Regulations”) that, if finalized, would have made a fundamental change to the definition of the “issue price” of tax-exempt bonds (the balance of the 2013 proposed regulations, which have been well received by the tax-exempt bond community, have not been withdrawn and remain under the Treasury’s consideration). In their place, Treasury released a revised notice of proposed rulemaking dealing with the determination of issue price (the “2015 Proposed Regulations”) (REG-138526-14), fixing several of the more troubling aspects found in the Withdrawn Regulations.  For example, the 2015 Proposed Regulations sharpen the overly broad definition of “underwriter”, which was set forth in the withdrawn Regulations, and the 2015 Proposed Regulations retain the current law threshold that establishes the issue price of a maturity at the price at which the first 10% of the maturity is sold to the general public (the Withdrawn Regulations would have raised this threshold to 25%).  However, the 2015 Proposed Regulations retain the most troublesome feature of the Withdrawn Regulations – they would still force issuers of obligations for which a bona fide public offering has been made to determine the actual issue price of the issue, rather than relying on the reasonable expectations of this price as of the sale date of the maturities, to establish the issue price of the issue.

Sadly, Treasury did not include an option to set the issue price through augury or rolls of a 20-sided die, although we note that we did correctly predict the blended approach (reduce 25% threshold to 10%, but stick with actual sales) in our April 1 post.  For those readers who simply cannot get enough information on this topic, please consider reviewing our article regarding the Withdrawn Regulations that appeared in Bloomberg by following this link.

A “Quick”  History Lesson.  (Ok, we admit that it is possible we are not being completely forthcoming.  This will not be quick, but we are tax lawyers and the word “quick” is not in our dictionary, and, the history is important to this discussion.)

The Statute. The original arbitrage rules trace back to the Tax Reform Act of 1969 which put the arbitrage rules into Section 103(d) of the Internal Revenue Code of 1954, as amended (“1954 Code”). See 83 Stat 656-657 (pages 170-171).  Later, as a result of a series of statutory amendments to the 1954 Code, the arbitrage rules were moved to Section 103(c) of the 1954 Code.  Section 103(c)(6)(H)(iii) of the 1954 Code contained a definition of yield which stated “The yield on the issue shall be determined on the basis of the issue price (within the meaning of section 1273 or 1274)”.  That same language is still in the current version of the Internal Revenue Code of 1986, as amended (“Code”) in Section 148(h).  Sections 1273 and 1274 focus on the price of a debt instrument from the perspective of the price a bondholder pays. Those sections are designed to determine the bondholder’s gain or loss when a bond with original issue discount is later sold and to prevent the deferral of recognition of the interest equivalent portion of the original issue discount.  Looked at solely in the context of the consequences to the bondholder, it makes sense to base the analysis on the price the bondholder pays.  But this cross-reference never made economic sense for purposes of determining the yield on a tax-exempt bond.  Many transactions involve two parties, a buyer and a seller and it makes sense that the seller’s sale price and the buyer’s purchase price should be the same for tax purposes.  In the issuance of tax-advantaged bonds, however, there is an intermediary between the borrower and the lender, which is the underwriter who makes the market for the bonds.  The tax law applicable to corporate, taxable transactions, where there is also an intermediary, tries to equate the price on securities as between the lender and the borrower.  That is consistent with the approach to two party transactions but not economically realistic in the case of tax-advantaged bonds. as discussed below. It seems this longstanding two-party concept was applied by cross-reference to tax-exempt bonds simply because it was convenient from a drafting perspective to tie to an existing rule and because it was an approach commonly used in other tax law contexts.  Unfortunately, convenience and seeming consistency, at the expense of logic, rarely makes for good policy.  But, it undoubtedly serves little purpose in 2015 to question what a Congressional staffer did in 1969.

The cross-reference has two fundamental flaws.  First, the price a bondholder pays is not the same as the borrower’s cost of funds because the borrower has to pay issuance costs, so the cross-reference never made much economic sense in the context of determining the yield on a tax-exempt bond.  To match economic reality, arbitrage yield should be based on the borrower’s cost of funds, inclusive of issuance costs, but that is not the case and that battle was lost a long time ago.  For those with an interest in that ancient battle, see State of Washington v. Commissioner, 692 F.2d 128 (1982).  Second, and most importantly for this purpose, using the price the bondholder pays does not solve the problem of being able to determine the issue price and yield of the bonds on their sale date.  A bond deal has to close on a specific date and, in many cases, the yield on the bond has to be known when the bonds are sold to the underwriter, which is in advance of the closing date of the bond issue.  But not all of the bonds are always sold on the sale date.  Often, the underwriter cannot sell certain maturities on the sale date.  Those maturities may be sold in bits and pieces over a period of time, often after the closing.    The cross-reference left this timing problem.  The longstanding solution to this timing problem, discussed below, was to use reasonable expectations as to the price on the sale date.

The Treasury Regulations.  In 1972, following somewhat slowly on the heels of the Tax Reform Act of 1969, the Treasury came out with the first proposed arbitrage regulations.  Final Treasury Regulations were promulgated in 1979.  Treas. Reg. § 1.103-13(c)(1) said the yield on an issue was to be determined by solving for the discount rate that would discount the cash flows of principal and interest on the issue back to the “purchase price”.  Treas. Reg. § 1.103-13(d)(2) said that the purchase price of a publicly offered security was the “initial offering price” to the public.  That provision used that phrase, initial offering price, because, as described above, Section 103(c) of the 1954 Code cross-referenced Sections 1273 and 1274 of the Code, which define the issue price of a publicly offered security as “. . . the initial offering price to the public (excluding bond houses and brokers) at which price a substantial amount of such debt instruments were sold.”

But these 1979 arbitrage regulations did make one crucial departure from the rules in Section 1273.  That change was to allow the initial offering price of a publicly offered bond to be based on reasonable expectations as of the sale date of the bonds (i.e., the date on which the underwriter purchases the bonds from the issuer, which is the date the bond purchase agreement is signed, which can sometimes occur the day after the actual sale) of the price at which the bonds will be sold to the general public. That reasonable expectations approach carried forward though the Tax Reform Act of 1986.  The treasury regulations promulgated under the Code were promulgated in 1993. Treas. Reg. § 1.148-1(b) defined issue price (the phrase “purchase price” was dropped) with a continuing cross-reference to Sections 1273 and 1274 but also kept the reasonable expectation approach while adding a number of enhancements to the definition as a result of experience accumulated since 1969.  Treas. Reg. § 1.148-1(b) stated that the issue price is based on the first price at which a substantial amount of the bonds was sold to the public and defined substantial amount to mean 10% of the bonds. Later sales at different prices are disregarded.  In the case of bonds for which a bona fide public offering is made, Treas. Reg. § 1.148-1(b) provides that the issue price is determined as of sale date based on the reasonable expectations of the initial offering price, not the price at which the bonds are actually sold to the general public.

Similarly, the definition of yield in Treas. Reg. § 1.148-4 defined yield with the same basic approach but enhanced to reflect the evolution of bond-related products that did not exist in 1969, such as credit enhancement in the form letters of credit and bond insurance, as well as swaps.

This reasonable expectations approach worked well for almost 40 years. But, particularly with the advent of direct payment subsidy bonds such as Build America Bonds (which have strict statutory limits on the amount of premium at which they can be sold) and the ability for the general public to follow tax-advantaged bond pricing on the MSRB’s electronic pricing website, EMMA, the IRS became concerned that, at least in its view, actual pricing may not have always tracked the reasonable expectations on the sale date.

The Withdrawn Regulations.  Those concerns led to the now Withdrawn Regulations, promulgated as a Notice of Proposed Rulemaking (78 FR 56842) on September 16, 2013.  The Withdrawn Regulations took a new and very different approach to the definition of issue price.  That 2013 Notice of Proposed Rulemaking invited comments from the public about the Withdrawn Regulations and wow, there were a lot of comments and not all of them were favorable.  Occasionally, and somewhat unfairly given that this was a first attempt to balance some difficult competing factors, you could almost feel the heat coming off the page.  Among the elements of the Withdrawn Regulations that attracted attention were (i) a change in the definition of “substantial” from 10% to 25%, (ii) an abandonment of reasonable expectations and a shift to the use of actual prices, potentially even after the bond issue had closed, and (iii) a definition of “underwriter” that seemed to pull in a broader group than what anyone would historically think of as an underwriter in a traditional sense.

Now, at Last, With That Important History in Mind, We Can Move on from the Dustbin of History to the Present.

The 2015 Proposed Regulations.  The 2015 Proposed Regulations take into consideration the comments that were submitted in response to the Withdrawn Regulations.  First, the 2015 Proposed Regulations restore the issue price threshold from 25% to the original 10%. Second, the 2015 Proposed Regulations dial back the definition of underwriter to include only: (1) any person that contractually agrees to participate in the initial sale of the bonds to the public by entering into a contract with the issuer or the lead underwriter to form a syndicate; and (2) any person that, on or before the sale date of the bonds, directly or indirectly enters into another arrangement to sell bonds, such as a retail distribution agreement. Third, the 2015 Proposed Regulations give two choices to set the issue price of the bonds.

One way to set the issue price under the 2015 Proposed Regulations is based on the first price at which a substantial amount (10%) of the bonds is sold to the public.  This concept is not new or startling, other than stripping issuers of their long-standing ability to use reasonable expectations.

The second way to set the issue price is a new concept, labeled as the “Alternative method based on initial offering price”.  If the underwriters have not received enough orders from the public by the sale date to reach the substantial amount threshold, the issuer may nonetheless treat the initial offering price (typically the price shown on the cover or the inside cover of the Official Statement for the offering of the bond issue) as the issue price if the following requirements are met:

  • the underwriter fills all of the orders placed on or before the sale date at the initial offering price and not at a higher price; and
  • the lead underwriter certifies to the issuer
  1. the initial offering price,
  2. that the underwriter met the requirement in the first bullet,
  3. no underwriter will fill an order placed by the public between the sale date and the closing date at a price higher than the initial offering price unless interest rates fall, and
  4. the lead underwriter provides supporting documentation as to the matters covered in (a) through (c).

If the underwriter sold a bond after the sale date and before the closing date at a price higher than the initial offering price, the underwriter must also provide documentation supporting the change in market prices (i.e., the change in interest rates).  The issuer must exercise its due diligence in relying on the underwriter’s certifications.

What is notably missing from the 2015 Proposed Regulations is the concept of reasonable expectations.  That concept, which worked so well for so long, is apparently still an unacceptable solution going forward as far as the federal government is concerned.

Procedural Matters.  The Notice of the 2015 Proposed Regulations calls for a public hearing and public comments.  While that date can change, the hearing is currently scheduled for October 28, 2015.  The 2015 Proposed Regulations do not permit an issuer to elect into them before they take effect. The effective date is not until 90 days after the 2015 Proposed Regulations become finalized.


Unless they reinstitute a reasonable expectations approach, the Treasury and the IRS will never be able to satisfy the marketplace given the difficulties in ascertaining the prices at which tax-advantaged bonds are first sold to the general public, which difficulties result from the convenient and consistent but somewhat flawed premise of the statute governing issue price (i.e., cross-referencing the issue price of tax-advantaged bonds to the issue price rules under Sections 1273 and 1274).  Nonetheless, the 2015 Proposed Regulations are certainly a significant step in the right direction compared to the Withdrawn Regulations, restoring one’s faith in the public hearing and comment process.

It is safe to say that there will be subsequent blog posts on this site about this topic, and the Treasury and IRS will undoubtedly receive more comments over the next couple of months, but those comments will likely be about fine-tuning rather than criticism.