Taxable debt tempts us to put the Internal Revenue Code back on the library shelf and the tax lawyers back into their pen. But if you use taxable debt to refund tax-exempt debt, or if you might ever refund that taxable debt with tax-exempt debt, then we regret to inform you that we ought to be involved. In a series of posts, we’re going to take a look at some of the questions and complications that arise when issuers and borrowers incorporate straight taxable debt into the same lineage as tax-exempt debt. First up: a taxable advance refunding of tax-exempt bonds.
It might seem odd that an issuer would consider issuing taxable debt, which generally has a higher interest rate than tax-exempt debt, to fund a long-term escrow at the low reinvestment rates that have prevailed for the past 15 years (what fancy folks call “negative arbitrage”) to retire tax-exempt debt. In certain rate environments, such as the present, where shorter-term interest rates applicable to refunding escrow securities are almost equal to the longer-term interest rates that apply to the refunding bonds, it can make sense. The prohibition against the issuance of tax-exempt debt to advance refund tax-exempt bonds enhances the incentive to issue taxable advance refunding bonds in this type of interest rate market.
When you’re assembling the working group to issue the taxable advance refunding bonds, you might be tempted to ignore the tax-exempt bond rules and the public finance tax lawyers on your team. Don’t. Let’s discuss why.
Let’s assume that an issuer issued tax-exempt bonds for a new money project in 2015. An astute financial adviser approaches the issuer this week, and lays out a compelling case – the issuer should issue taxable advance refunding bonds to advance refund the tax-exempt bonds. There’s a trap here. Let’s walk through it step by step.
Step 1: At first glance, the funds deposited into the escrow look like both sale proceeds of the taxable advance refunding bonds and replacement proceeds of the tax-exempt refunded bonds.
When the issuer issues the 2019 taxable advance refunding bonds and deposits the taxable bond proceeds into the refunding escrow, those dollars have a split personality. On the one hand, they are “sale proceeds” of the 2019 taxable bonds, because the issuer receives them “from the sale of the issue.” But the amounts in the escrow are also replacement proceeds of the 2015 tax-exempt bonds to be refunded, because they are pledged to pay debt service on the 2015 tax-exempt refunded bonds. In other words, based on general principles, the proceeds of a taxable advance refunding bond issue have a clear connection to the underlying tax-exempt bonds. We need a rule to tell us which trumps – should the proceeds of the taxable advance refunding issue be treated as sale proceeds of a taxable issue, which aren’t subject to the arbitrage rules? Or, should they instead be treated as replacement proceeds of the tax-exempt refunded bonds, which are subject to the arbitrage rules?
Step 2: A handy ordering rule tells us that sale proceeds trump replacement proceeds.
The arbitrage rules give us a clear answer. If amounts are simultaneously proceeds of one issue and replacement proceeds of another issue, they stick to the issue of which they’re proceeds.  You have used this rule before, though maybe you didn’t know it – in a tax-exempt advance refunding. This is why the sale proceeds of the refunding issue that are deposited in the refunding escrow are subject to yield restriction at the yield of the tax-exempt advance refunding bonds (i.e., the bonds of which they are proceeds) rather than the yield of the refunded bonds (i.e., the bonds of which they are replacement proceeds). In the tax-exempt advance refunding case, the question is “which yield?” In the taxable advance refunding case, the question is “yield restriction or not?”
At this point in the game, after steps one and two, our 2019 taxable advance refunding bond proceeds are not subject to the Section 148 arbitrage restrictions because they remain proceeds of the taxable advance refunding issue rather than replacement proceeds of the 2015 tax-exempt refunded bonds.
Step 3: In certain cases, the “universal cap” can cause taxable advance refunding bond proceeds to magically lose their character as proceeds of the taxable advance refunding bond issue and transform into replacement proceeds of the tax-exempt bond issue, meaning that they become subject to the arbitrage restrictions at some point in the future after the issuance of the taxable advance refunding bonds.
The universal cap sounds magnificently mysterious (“A hat for all mankind?”). In fact, it is a rule that works just like most tax rules do – it describes an obvious conclusion but then spawns all manner of devilry in the non-obvious cases.
To start with an obvious case, if you use money that isn’t borrowed money to retire an issue of tax-exempt bonds that has unspent proceeds, those proceeds generally aren’t subject to the arbitrage restrictions once the bonds are paid off. The Treasury regulations express this rule as follows:
Except as otherwise provided below, amounts that would otherwise be gross proceeds allocable to an issue are allocated (and remain allocated) to the issue only to the extent that the value of the nonpurpose investments allocable to those gross proceeds does not exceed the value of all outstanding bonds of the issue.
In other words, these regulations set up a basic comparison: what’s the value of the nonpurpose investments acquired with bond proceeds, and what’s the value of the bonds? To the extent that the first number exceeds the second number, then that amount of nonpurpose investments is “deallocated” (ugh) from the bond issue. The Treasury regulations provide detailed rules that tell us how to value investments and bonds for this purpose. But we can focus on the basic comparison for now.
You could think of the universal cap like an ice cream cone (the world’s most boring ice cream cone). Most people (even tax lawyers) eat an ice cream cone by taking bites with varying proportions of ice cream and cone, but everyone has had the experience of biting off too much cone and the ensuing tragic loss of delicious ice cream. The value of bonds is the cone, and the value of investments is the ice cream. If the proportion of cone bites to ice cream bites gets too high, then the ice cream investments will spill out of the cone as they become deallocated from the cone.
However, that’s not the end of the story. First of all, the universal cap applies to proceeds of an “issue.” The term “issue” includes both tax-exempt and taxable bonds, so these rules would apply to a taxable advance refunding. Second, and more significantly, once the universal cap causes proceeds to be deallocated from one issue, they can become allocated to another issue. In other words, the ice cream that spilled out of your cone could land on someone else’s.
In the case of what you thought was a plain-vanilla taxable advance refunding, these rules could leave you in a sticky situation. If the universal cap ever applies to the taxable advance refunding bond issue, then the escrowed securities that were purchased with sale proceeds of the taxable advance refunding bonds and that haven’t yet matured will become deallocated from the taxable advance refunding bond issue. However, because those escrowed securities were purchased with amounts that have a split personality (they are both sale proceeds of the taxable advance refunding bonds and replacement proceeds of the tax-exempt refunded bonds), the escrowed securities that are deallocated from the taxable advance refunding issue will become allocated to the tax-exempt refunded bonds for the first time. These securities therefore will become subject to yield restriction for the first time.
The fair market value and, thus, the yield of the escrowed securities that become allocated to the tax-exempt advance refunded bonds will be determined at the time of this allocation for purposes of ensuring compliance with yield restriction. In other words, the fair market value and yield of the escrowed securities that were determined upon their purchase will not, except by pure happenstance, apply – the reallocated escrowed securities must instead be “marked-to-market.” This is true even in the case of United States Treasury Securities – State and Local Government Series (affectionately known as “SLGS”).
We’d bet that you can see why subjecting securities that were acquired with taxable bond proceeds to yield restriction at 0.001% above the yield of a tax-exempt issue might be a problem. If the taxable advance refunding has been organized like “The Cask of Amontillado,” with the deal team playing Montresor to the public finance tax lawyer’s Fortunato, it would not be at all surprising if the escrowed securities were acquired at a yield that is (far more than) materially higher than the yield of the tax-exempt advance refunded bonds.
Worse, because the escrowed securities that become deallocated from the taxable bonds (the ice cream that spilled out of the cone) must be “marked-to-market” on the date that they become deallocated from the taxable advance refunding bonds and allocated to the tax-exempt bonds. If market interest rates are higher on the reallocation date than they were on the date the SLGS were purchased, the fair market value of the SLGS will have declined and their yield will have increased. If the yield of the SLGS on the reallocation date is materially higher than the yield of the tax-exempt bonds, the investment of gross proceeds of the tax-exempt bonds in the SLGS will not comply with yield restriction, even though it would have complied at the time the SLGS were purchased.
Although yield reduction payments are not available in all cases, they are available here. In other words, the issuer could make a payment to the IRS (similar to a rebate payment) that will be taken into account to reduce the yield on the deallocated securities to the yield on the tax-exempt advance refunded bonds. Although this solves the yield restriction problem, and therefore preserves the tax-exempt status of the advance refunded bonds, it is cold comfort to the issuer, who will not relish making an unanticipated payment (in some cases, a substantial payment) to the IRS that amounts to a direct reduction of the debt service savings in the deal.
Step 4: Armed with this knowledge about the “universal cap,” what do you do now?
The ominous tenor of this post notwithstanding, we do not intend to be alarmist. In most cases, the universal cap will not apply to the taxable advance refunding bonds. Many advance refunding escrows funded with taxable bonds will fully mature before the second anniversary of the issuance date of the taxable advance refunding bonds, which renders the universal cap moot (more on this below). Moreover, in most taxable advance refundings, the taxable advance refunding bonds don’t start amortizing significantly until after the escrowed securities mature and the escrow pays out to retire the tax-exempt advance refunded bonds. In other words, the amount of cone is always much greater than the amount of ice cream. However, there are cases where it will make economic sense to the issuer to begin making significant principal payments on the taxable advance refunding bonds before the refunding escrow pays out. In these cases, it is possible that at some point the value of the nonpurpose investments in the advance refunding escrow will exceed the value of the outstanding taxable advance refunding bonds. As discussed at length above, should that happen, the excess amounts will be deallocated from the taxable advance refunding bond issue and allocated to the tax-exempt advance refunded bond issue.
So, what is a conscientious issuer to do? Although the deallocation of investments from the taxable advance refunding bonds to the tax-exempt advance refunded bonds sounds “unexpected,” it isn’t difficult to figure out on the issue date whether the universal cap will apply to a particular issue of tax-exempt or taxable bonds. This is because everyone will know the amortization schedule of the taxable advance refunding bonds and the amortization schedule of the escrow investments – indeed, the parties will specifically plan them. Thus, an easy way to avoid spilled ice cream is to tamp down the amortization of the taxable advance refunding bonds so that the value of the investments in the refunding escrow doesn’t ever exceed the value of the outstanding taxable advance refunding bonds. If the issuer otherwise likes the economics produced by a comparably rapid amortization of the taxable advance refunding bonds, then the issuer can take its chances, accepting the bargain that when investments in the refunding escrow are deallocated from the taxable advance refunding bonds and the issuer marks their yield to a market yield, the issuer will have to pay any positive arbitrage to the IRS.
There’s another way to make life easier. In general, we don’t have to apply the universal cap rule until the first day of the bond year that begins after the second anniversary of the issue date of the taxable advance refunding issue. A bond year for any issue is the one-year period that ends on the day selected by the issuer, and the first and last bond years can be short periods. If the issuer does not select an ending date for the bond years within five years after the bonds are issued, then the bond years for the issue will conclude on each anniversary of the issue date and, in the case of the issue’s last bond year, the final maturity date of the issue. In most cases, the issuer does not select a bond year that differs from this default rule. However, the issuer is allowed to do so, and it can be beneficial here.
Here’s an example of how strategic selection of the bond year can help avoid the requirement to test whether the universal cap applies to the taxable advance refunding issue. If an issuer issues taxable advance refunding bonds on December 1, 2019, and does not select an ending date for the bond years, each bond year will end on December 1. In such a case, the universal cap must be determined as of December 2, 2021, which is the first bond year that commences after December 1, 2021, the second anniversary of the issue date of the taxable advance refunding bonds. If the issuer instead selects November 29 as the ending date for each bond year (because it was advised that the first and last year bond year can each be a period of less than one year), the first bond year that commences after December 1, 2021 would be on November 30, 2022, almost a full year later than would be the case if the issuer did not select an ending date for the bond years. If the advance refunding escrow has fully matured by November 30, 2022 (which is almost three years after the issuance date of the taxable advance refunding bonds), there would be no need to determine the universal cap that would otherwise apply to the taxable advance refunding issue.
As we said, there are a number of complications to the basic comparison of the value of investments of bond proceeds to the value of the bonds and the idea that the value of the bonds is a universal cap. They go far beyond this already-too-long blog post. Those complications, and the fact that adequately preparing for this circumstance requires adequate planning before the deal closes, should underscore the fact that you ought to consult the public finance tax lawyers on any taxable issue and on any advance refunding issue, even if they’ll ruin your dessert.
 Treas. Reg. § 1.148-1(b). Under the Section 148 and Section 150 Treasury regulations, the term “issue” includes both issues of tax-exempt bonds and issues of taxable bonds issued by a state or local governmental unit; consequently, unless the Section 148 Treasury regulations specifically tell us otherwise, they apply with equal force tax-exempt and taxable issues.
 Treas. Reg. § 1.148-6(b)(1). “Proceeds” of an issue are sale proceeds, investment proceeds, and transferred proceeds of that issue. Treas. Reg. § 1.148-1(b). Replacement proceeds are not proceeds of an issue, but when paired with the proceeds of an issue, they comprise the “gross proceeds” of an issue. Id.
 Technically, “0.001% above the yield.” Treas. Reg. § 1.148-2(d)(2)(ii).
 Or, you could say that it’s also a question of “which yield?” where your choices are [infinity] (in the case of the taxable refunding bonds) or the somewhat lower yield of the tax-exempt advance refunded bonds.
 An exception would be if those unspent proceeds then become replacement proceeds of a different tax-exempt bond issue.
 Treas. Reg. § 1.148-6(b)(2)(ii).
 A “nonpurpose investment” is any investment property other than a “purpose investment,” and a purpose investment is any investment acquired to carry out the governmental purpose of the issue. Treas. Reg. § 1.148-1(b). A purpose investment includes the use of bond proceeds to acquire an investment (such as a loan to a conduit borrower) in order to carry out the governmental purpose of an issue. The expenditure of proceeds (or gross proceeds) to acquire securities held in a defeasance escrow is a nonpurpose investment.
 See Treas. Reg. § 1.148-6(b)(2).
 Even public finance tax lawyers.
 A loss that is compounded if it entails an emergency laundry session.
 In general, they can only be allocated to another issue as replacement proceeds of that issue, except in the case of certain transferred proceeds, as described in Treas. Reg. § 1.148-9(b)(3).
 Vanilla being the stickiest of all ice creams.
 Treas. Reg. § 1.148-5(d)(3)(i). An exception to this requirement that reallocated investments be valued at the time of the reallocation exists where the universal cap operates to reallocate nonpurpose investments from a tax-exempt bond issue to another issue. Treas. Reg. § 1.148-5(d)(3)(ii). This exception is unavailing here, because the universal cap applies in this case to reallocate nonpurpose investments from a taxable issue to a tax-exempt issue.
 In the comments, please leave your guess about which one of your co-authors provided the “ice cream cone” reference and which one provided the Edgar Allan Poe reference. Note that this yield restriction problem is magnified if prevailing interest rates are higher on the reallocation date than they were when the escrowed securities were purchased. If that’s the case, the fair market value of the securities will have declined, and their yield at the time of reallocation will exceed the yield of the refunded tax-exempt bonds by even more.
 Treas. Reg. § 1.148-5(c)(3)(vi) (stating that yield reduction payments are available only for “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. . . . (vi) Nonpurpose investments allocable to certain replacement proceeds of refunded issues. Nonpurpose investments allocated to replacement proceeds of a refunded issue, including a refunded issue that is an advance refunding issue, as a result of the application of the universal cap to amounts in a refunding escrow.”).
 And not the delicious kind afforded by a cone, or bowl, of ice cream.
 You would probably call the police if you saw someone eating an ice cream cone in the way that this analogy would suggest here, but stay with us.
 [ED: Their gratuitous similes of dessert disaster didn’t exactly help.]
 On that date, the value of the outstanding taxable advance refunding bonds (i.e., the amount of the universal cap) and the value of the outstanding nonpurpose investments initially acquired with proceeds of the taxable advance refunding issue must be determined, and these values must be determined as of the first day of each subsequent bond year (until the commencement of a bond year on which there are no remaining nonpurpose investments). Treas. Reg. § 1.148-6(b)(2)(iii).
 Treas. Reg. § 1.148-1(b).