A few weeks ago, Joel began our coverage of the President’s FY 2017 budget proposals [Link] by describing several of the bond proposals.  [Link]  After a short break to talk football among other things (we’ll do whatever it takes to keep you readers coming back!) [Link], we’re back to the budget proposals, this time with a couple of my favorites – the private activity bond and arbitrage simplification proposals.  To be clear, we don’t expect any near-term enactment of these proposals, but we have seen many times bond proposals develop over several generations of proposals to ultimately be enacted into law.  Thus despite the Washington stalemate, these proposals continue to attract our attention.

Simplification of the Private Activity Bond Limits

The President’s proposal to simplify the private activity bond limits is a good example of a proposal that has been around for many years and hopefully will be enacted soon.  The centerpiece of this proposal is elimination of the 5% limit on “unrelated or disproportionate” private business use.  This is one of the most convoluted rules for tax-exempt bonds.  Probably like many of the readers of this blog, I’ve had many occasions over the years to explain this limit to bond lawyers and clients but unless a person does 103 tax work on a full time basis I doubt many have the interest or available brain cells to keep this minutiae in their minds.  And even for those who understand the principles of this limit, gray areas abound.  Given the scant authority, it is often impossible to distinguish between related and unrelated private business use.  As the proposal states under “Reasons for Change,” “The additional five-percent limit on unrelated or disproportionate private business use introduces undue complexity, a narrow disqualification trigger, and attendant compliance burdens for State and local governments.”  This degree of complication cannot be justified for a set of rules that merely fine-tunes an already small permitted amount of private business use/private payment or security.  The insignificance of this 5% limit is demonstrated by the small budget impact projected for this change:  $81 million over 10 years – as proposed changes go, clearly one of the smaller.

This proposal would also eliminate the $15 million private business use limit on nongovernmental output facilities, another trap that comes into play for very few issues (the small impact of its repeal is included in that $81 million amount).  Further, in the interest of setting the private limits at a more uniform 10% level, the private loan limit would be increased to 10% (which also eliminates the $5 million private loan limit).  Unfortunately this simplification proposal would not eliminate the requirement for volume cap where private business use exceeds $15 million, and would expand this rule also to cover private loans in excess of $15 million.  Of course, this $15 million limit can be avoided by carving large bond issues into multiple issues not exceeding $150 million, but this is an unnecessary, federally-imposed waste of state and local governments’ time and resources.

Simplification of Arbitrage Restrictions

Yield Restriction

This long-awaited and much-needed simplification of the arbitrage regulations would, in the words of the proposal, “unify” the yield restriction and rebate requirements – which really just means eliminate almost all yield restrictions.  For issuers, this would mean that they would only need to keep one set of requirements in mind; for tax lawyers, this would mean we’d no longer have to struggle explaining to our clients why there are two sets of requirements having precisely the same function.  But once again, Treasury’s dislike of advance refundings gets in the way of true simplification.  Even though issuers have long been limited to just one advance refunding, even the one permitted advance refunding would remain subject to yield restriction.  The only conceivable explanation for keeping yield restriction around is to impose an additional nuisance – which translates into transaction costs – on issuers of advance refunding bonds, since yield restriction yields provides no additional benefit to Treasury when the rebate requirements remain in place (other than discouraging that one permitted advance refunding).  In addition, the proposal would authorize Treasury to impose additional yield restrictions through regulations.


On a further positive note, the proposal would provide a much more generous and simple spending exception to the rebate requirement.  In short, most bond issues would be exempt from rebate if at least 95% of the proceeds were spent within 3 years and the issuer exercised due diligence in spending the proceeds.  To be eligible for this exception, the bonds would be required to have a fixed yield and a weighted average maturity of at least 5 years.  (Note that, e.g., a bank placement with a 5-year fixed rate followed by a bank put to be followed by a remarketing would not qualify because the fixed rate must run the entire term of the issue.)   Important changes to the current spending exceptions are that  (i) the proposal would remove the interim 6-month spending requirements to satisfy  the 18-month and 24-month spending exceptions, and (ii) as a result of the 95% requirement, an issuer would not be penalized by failing to spend all but a de minimis amount of proceeds by the deadline; put differently, the 95% requirement would expand the de minimis allowance to 5% of the proceeds.

In addition, the new rebate exception in the proposal would apply to all types of bond issues (except as stated below), including non-construction issues and private activity bonds.  The only bonds not eligible for this rebate exception would be the evil advance refundings and working capital financings.  Once again, the proposal targets disfavored types of bonds even though they represent no greater loss to Treasury through arbitrage profits than any other type of bond issue.  In fact, the exclusion of advance refundings from the generous new rebate exception in the proposal would seem to be just a gratuitous slap at issuers of advance refunding bonds since those bonds would still be subject to yield restriction.

Finally, the small issuer exception to the rebate requirement would be increased from $5 million to $10 million of bonds issued in a given year, and the requirement that the issuer have “general taxing power” to take advantage of the small issuer exception would be eliminated.  It is not clear how this change would interact with the existing small issuer exception as expanded to $10 million for the financing of construction of public school facilities.  Further, in a positive step that should be applied to all dollar-denominated limitations, the $10 million limit would be indexed for inflation.

While we cannot expect enactment of these positive steps toward simplification and rationalization of the tax-exempt bond rules, we can hope that when Washington again becomes functional these proposals will be included in an early tax act.