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TEB Self Correction: Some Basic Concepts

Tax Exempt Bonds (TEB) focuses on providing participants in the municipal bond industry with quality service to assist issuers and conduit borrowers in understanding their tax responsibilities. As part of that service, TEB is providing the following general basic information for issuers of tax-exempt bonds with respect to remedial actions and other self-correction options available under the Income Tax Regulations (Regulations). Issuers can use these remedial action provisions to resolve tax violations without the involvement of TEB. The issuer may not cite this information as an authoritative source. TEB recommends that issuers of tax-exempt bonds review these remedial action provisions in consultation with their counsel.

Remedial Actions for Violations of Qualification Requirements

Even though an issuer might reasonably expect on the issue date to satisfy all applicable federal tax requirements relating to the qualification of the bonds for so long as the bonds will remain outstanding, post-issuance events can occur that jeopardize compliance with these requirements. For example, an issuer leases property financed with governmental bonds to a private party in a manner that results in a violation of the private business tests under section 141 of the Internal Revenue Code (Code). Similarly, a conduit borrower uses property financed with qualified private activity bonds for nonqualified purposes. The Regulations provide certain remedial actions that issuers can take to preserve the tax-exempt status of their bonds in these and other instances.

Remedial Actions for Governmental Bonds & Qualified 501(c)(3) Bonds

A governmental bond issue can lose its tax-exempt status, even if on the issue date the issuer satisfied the reasonable expectation test under section 1.141-2(d) of the Regulations, if the issuer takes a deliberate action, subsequent to the issue date, which causes the issue to meet the private business tests or private loan financing test.  See Publication 4079, Tax-Exempt Government Bonds Compliance Guide, for more information about the qualification requirements applicable to governmental bonds.

A qualified 501(c)(3) bond issue can lose its tax-exempt status, even if on the issue date the issuer satisfied the reasonable expectation test under section 1.141-12(d) of the Regulations, if the issuer or conduit borrower 501(c)(3) organization takes a deliberate action which causes the issue to fail to comply with the tax requirements applicable under sections 141(e) and 145 of the Code.  See Publication 4077, Tax-Exempt Bonds for 501(c)(3) Charitable Organizations Compliance Guide, for more information about the qualification requirements applicable to qualified 501(c)(3) bonds.

A deliberate action is generally defined under section 1.141-2(d)(3) of the Regulations as any action taken by the issuer that is within its control.  Intent to violate the requirements of section 141 of the Code is not necessary for an action to be deliberate.  A deliberate action occurs on the date the issuer enters into a binding contract with a nongovernmental person for use of the financed property that is not subject to any material contingencies.

An issuer of governmental bonds that takes a deliberate action causing the bond issue to meet the private business tests or the private loan financing test may take a remedial action described in section 1.141-12 of the Regulations to resolve the deliberate action and preserve the tax-exempt status of the bonds.  Such actions may include redemption or defeasance of nonqualified bonds, alternative use of disposition proceeds, and alternative use of bond-financed property.  Generally, the redemption or defeasance of nonqualified bonds must occur within 90 days of the date of the deliberate action.  If a defeasance escrow is established, the issuer must provide notice of such defeasance to the Commissioner within 90 days of the escrow’s establishment.  A defeasance escrow cannot be used if the period between the issue date and the first call date is more than 10.5 years.  Also, generally, the alternative use of disposition proceeds must occur within 2 years of the date of the deliberate action.  Section 1.141-12 of the Regulations provides definitions of the terms disposition proceeds and nonqualified bonds as well as other special rules required for these remedial actions.

Under section 1.145-2(a) of the Regulations, an issuer of qualified 501(c)(3) bonds may take a remedial action described in section 1.141-12 of the Regulations to resolve a deliberate action and preserve the tax-exempt status of the bonds, including redemption or defeasance of nonqualified bonds, alternative use of disposition proceeds, and alternative use of bond-financed property as described above for governmental bonds.  Additionally, if the alternative use of disposition proceeds is by a 501(c)(3) organization, the nonqualified bonds must be treated as reissued for purposes of section 141, 145, 147, 149 and 150 of the Code and, as such, satisfy all tax requirements applicable to qualified 501(c)(3) bonds.

Remedial Actions for Exempt Facility Bonds

An issue of exempt facility bonds can lose its tax-exempt status if there is a failure to properly use proceeds.  Such a failure occurs when less than 95% of the net proceeds of the issue are used to provide an exempt facility as described in section 142(a) of the Code or an action is taken that causes the bonds to not be used for the qualifying purpose for which they were issued.  See Publication 4078, Tax-Exempt Private Activity Bonds, for more information about the qualification requirements applicable to exempt facility bonds.

Under section 1.142-2 of the Regulations, an issuer of exempt facility bonds may resolve a failure to properly use proceeds and preserve the tax-exempt status of the bonds, provided the issuer met the reasonable expectations requirement under section 1.142-2(b) of the Regulations on the issue date.  Generally, the issuer must redeem the nonqualified bonds on the earliest call date after the date the failure occurs.  If the bonds are not redeemed within 90 days of the failure, a defeasance escrow must be established within 90 days of the date of the failure.  If a defeasance escrow is established, the issuer must provide notice of such defeasance to the Commissioner within 90 days of the escrow’s establishment.  A defeasance escrow cannot be used if the period between the issue date and the first call date is more than 10.5 years.

Remedial Actions for Qualified Small Issue Bonds

An issue of qualified small issue bonds can lose its tax-exempt status if there is a failure to properly use proceeds.  Such a failure occurs when less than 95% of the net proceeds of the issue are used to provide certain manufacturing facilities or certain depreciable farm property that meets other requirements applicable under section 144(a) of the Code.  See Publication 4078 for more information about the qualification requirements applicable to qualified small issue bonds.

Under section 1.144-2 of the Regulations, an issuer of qualified small issue bonds may resolve a failure to properly use proceeds and preserve the tax-exempt status of the bonds under the remedial action provisions described in section 1.142-2 of the Regulations by treating the qualified small issue bonds as exempt facility bonds and the qualifying purposes under section 144(a) as exempt facilities.

There are no remedial action provisions to address post-issuance compliance violations of sections 144(a)(4) or 144(a)(10) of the Code relating to the limitations on capital expenditures or authorized face amount.

Remedial Actions for Other Requirements Applicable to Certain Private Activity Bonds

Qualified private activity bonds must satisfy certain generally applicable federal tax requirements under section 147 of the Code.  A failure to satisfy these requirements can result in a loss of the qualified private activity bond issue’s tax-exempt status.  See Publication 4078 for more information about the general requirements applicable to qualified private activity bonds.

Under section 1.147-2 of the Regulations, an issuer of qualified private activity bonds may resolve a failure to comply with certain requirements under section 147 of the Code and preserve the tax-exempt status of the bonds under the remedial action provisions described in section 1.142-2 of the Regulations by treating the private activity bonds as exempt facility bonds and the qualifying purposes as exempt facilities.

Remedial Actions for Violations of Arbitrage Requirements

Even though an issuer might reasonably expect on the issue date to satisfy all applicable federal tax requirements under section 148 of the Code for so long as the bonds will remain outstanding, post-issuance events can occur that jeopardize compliance with these requirements and cause the issue to consist of arbitrage bonds.  For example, an issuer may use bond proceeds to acquire investment property which produces a yield over the term of the bond issue which is materially higher than the yield on the bond issue.  Similarly, an issuer may use bond proceeds to replace funds which were used to acquire higher yielding investments.

A tax-exempt bond issue can lose its tax-exempt status if the issuer takes an intentional act, subsequent to the issue date, that causes the issue to consist of arbitrage bonds.  Under section 1.148-2(b) of the Regulations, the determination of whether a bond issue consists of arbitrage bonds is based on the issuer’s reasonable expectations as of the issue date regarding the amount and use of the gross proceeds of the bond issue.  An intentional act is generally defined under section 1.148-2(c) of the Regulations as a deliberate, intentional action by the issuer (or a person acting on the issuer’s behalf) after the issue date to earn arbitrage if that action, had it been expected on the issue date, would have caused the bonds to be arbitrage bonds under section 148 of the Code.  Intent to violate the requirements of section 148 is not necessary for an action to be an intentional act.  See Publications 4077, 4078 and 4079 for more information about the arbitrage yield restriction and rebate requirements applicable to tax-exempt bonds.

An intentional act cannot be remediated.  However, in certain instances, the issuer may be allowed to file Form 8038-T, Arbitrage Rebate, Yield Reduction and Penalty in Lieu of Arbitrage Rebate, to pay a yield reduction payment to resolve the noncompliance.  If an issuer is not permitted to pay a yield reduction payment under the Regulations, the issuer can submit a request under the TEB Voluntary Closing Agreement program (TEB VCAP) to conclusively resolve the matter.

Page Last Reviewed or Updated: 18-Apr-2014