At least 95% of the net proceeds of exempt facility bonds must be used to provide an exempt facility, and at least 95% of the net proceeds of qualified small issue bonds must be applied to property of a character subject to the allowance for depreciation. Original issue discount in the sale of exempt facility bonds and small issue bonds may affect compliance with the 95% expenditure requirement through the addition of "imputed proceeds" to the amount of net proceeds. This issue snapshot discusses the regulations that govern the determination of the amount of imputed proceeds that arise from deep discount sales.
IRC Section and Treas. Regulation
Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)
Private activity bonds are generally not exempt from federal income tax. However, the Internal Revenue Code (the "Code") allows for tax-advantaged financing for certain qualified private activity bonds. These include exempt facility bonds if 95% of the net proceeds are used to provide an exempt facility and qualified small issue bonds if 95% of the net proceeds are to be used for the acquisition, construction, reconstruction, or improvement of land or property of a character subject to the allowance for depreciation.1 Determining whether 95% of the net proceeds of exempt facility bonds or qualified small issue bonds were used for qualified facilities requires determination of (1) the “net proceeds” of the issue and (2) the expenditures to which the net proceeds were properly allocated.
Code Section 150(a)(3) defines “net proceeds” as the proceeds of an issue less amounts used to fund a reasonably required reserve or replacement fund. This is applicable for all purposes of Sections 103 and 141 through 150. Because Code Section 141(e)(1) provides that exempt facility bonds described in Code Section142 and qualified small issue bonds described in Code Section 144(a) are qualified private activity bonds eligible for tax-exemption, use of the definitions related to “proceeds” found in Code Section 141 are applicable to determine "proceeds" under Sections 142 and 144(a) unless otherwise noted.
Prior to the Tax Reform Act of 1986, the Internal Revenue Code of 1954 contained the provisions relating to the exemption for interest on state and local bonds in Section 103. This included the provisions on qualification requirements for exempt facility bonds and small issue industrial development bonds, which are now found in Code Sections 142 and 144(a), respectively, and rules for determining the amount of proceeds, found in part in Treasury Regulation Sections 1.103-8(a)(6) and 1.103-8(a)(7). The Conference Committee report on reconciliation of the House and Senate bills that resulted in the Tax Reform Act of 1986, notes:
Like the House bill, the conference agreement reorganizes and amends the present-law rules governing tax-exemption for interest on obligations issued by or on behalf of qualified governmental units. As part of this reorganization, the present-law rules contained in Code Sections 103 and 103A are divided, by topic, into 11 Code Sections (secs. 103 and 141-150). The conferees intend that, to the extent not amended, all principles of present law continue to apply under the reorganized provisions.
While some regulations in effect prior to the Tax Reform Act of 1986 have been amended or removed by subsequent regulations, Treasury Regulation Sections 1.103-8(a)(6) and 1.103-8(a)(7) have not been modified.
Treasury Regulation Section 1.103-8(a)(6)(i) provides: "(i) Except as otherwise provided in paragraph (a)(7) of this Section, the proceeds of any issue of obligations sold by the issuer after June 4, 1982, shall include any imputed proceeds of the issue. The imputed proceeds of an issue equal the sum of the amounts of imputed proceeds for each annual period (hereinafter, bond year) over the term of the issue." Thus, such imputed proceeds are part of net proceeds, and will be part of the determination of whether 95% of the net proceeds of the issue were applied to a required purpose. Unlike investment proceeds, which are only included in proceeds for purposes of Sections 141, 142 and 144(a) of the Code during the project period, imputed proceeds are determined over the term of the issue.
Determining the amount of imputed proceeds essentially is a year-by-year determination of the amount by which the accrual of interest on the issue, determined using the yields on the obligations in the issue, is less than the amounts payable on the issue. This annual determination is made separately for each obligation in the issue, and then aggregated. Treasury Regulation Section 1.103-8(a)(6)(ii) provides the method for computing the amount of imputed proceeds for each annual period (bond year). The amount of imputed proceeds for a bond year equals the sum of the amounts of interest that will accrue with respect to each obligation that is part of the issue in such year, reduced (but not below zero) by the sum of the amounts of principal and interest that become payable with respect to the issue in that bond year.
The regulation provides that the amount of interest accruing, and the amount of principal and interest payable, in a year is determined by including accruals and payments in prior years. Interest will be deemed to accrue in a year with respect to an obligation on an amount that, as of the commencement of that year, is equal to the sum of (a) the purchase price (as defined in Section 1.103-13(d)(2)) allocable to the obligation and (b) the aggregate of the amounts of interest accruing in each prior bond year with respect to the obligation, reduced by all amounts that became payable with respect to the obligation in prior bond years. The regulation also provides that any amount that becomes payable during the 30-day period following any bond year will be deemed to have become payable in such bond year. Thus, to the extent interest on an obligation accruing during a bond year does not become payable within 30 days from the end of such year, it is treated as reinvested under the same terms as the obligation. For purposes of Section 1.103-8(a)(6), the rate at which such interest accrues is equal to the yield of the obligation. Yield is computed in the same manner as set forth in Section 1.103-13(c)(1)(ii) for computing yield on governmental obligations (assuming annual compounding of interest). Such computations shall be made without regard to optional call dates.
Treasury Regulation Section 1.103-13(d)(2) defining "purchase price" has been withdrawn, but the definition of purchase price therein was essentially the same as the definition of "issue price" under Treasury Regulation Section 1.148-1(b) prior to amendment in 2016. Thus, the issue price of the obligation should be used as the "purchase price" of the obligation when determining imputed proceeds. The definition of "yield" in withdrawn regulation Section 1.103-13(c)(1)(ii) has yield determined over the term of the obligation and is similar to the definition of yield for a fixed yield issue in Treasury Regulation Section 1.148-4(b)(1), except that the withdrawn definition does not mention fees for qualified guarantees or qualified hedges, as such were in limited use in 1979 when the older regulation became effective. Variable rate bonds were in limited use in 1979, but the regulation addresses how to determine yield when the payments on an obligation are not determinable when the obligation is issued. Thus, it is appropriate to use the definition of yield for fixed yield bonds found in the current regulations to determine the rate of accrual of interest on the obligations in an issue for purposes of calculating the amount of imputed proceeds, with the adjustment described in the following paragraph for variable yield bonds.
Treasury Regulation Section 1.103-8(a)(7)(ii) provides that if the actual rate at which interest is to accrue over the term of an obligation is indeterminable at the date of issue then, in computing the yield of the obligation for purposes of determining imputed proceeds, such rate shall be determined as if the conditions as of the date of issue will not change over the term of the obligation. Thus, for example, if interest on an obligation is to be paid semiannually at a rate equal to 80 percent of the yield on six-month Treasury bills at the most recent public sale immediately prior to the corresponding interest payment date and the yield on six-month Treasury bills sold immediately preceding the issue date is 10 percent, then the six-month Treasury bill rate is deemed to be a constant 10 percent for purposes of determining the amount of imputed proceeds of the issue. Therefore, all interest payments on the obligation would be deemed to be made at a rate of 8 percent.
Treasury Regulation Section 1.103-8(a)(7)(i) provides that there are no imputed proceeds with respect to an obligation if the obligation does not have a stated interest rate (determinable at the date of issue) that increases over the term of the obligation, and the purchase price of the obligation is at least 95 percent of its face amount. The regulation also provides that, at the option of the issuer, any obligation described in the preceding sentence may be disregarded in computing the imputed proceeds of the issue. Payments with respect to such obligations are also disregarded in determining the amount payable with respect to the issue in that bond year. If every obligation which is part of an issue is described in Section 1.103-8(a)(7)(i) (that is, the obligation does not have a stated interest rate that increases over the term of the obligation and the issue price for each obligation is at least 95 percent of the stated redemption price at maturity for such obligation), there are no imputed proceeds with respect to the issue.
Treasury Regulation Section 1.103-8(a)(8) provides several examples of applying the "deep discount" rules.
Issue Indicators or Audit Tips
Steps to analyze imputed proceeds from deep discount.
A. Determine if imputed proceeds are relevant to compliance for the bond issue.
- Is the bond issue one in which imputed proceeds may affect compliance? These are bond issues that require a certain percentage of the proceeds to be spent for capital expenditures for a specific purpose, such as bonds for solid waste disposal facilities, residential rental projects, and other projects eligible for exempt facility bond financing, and qualified small issue bonds for manufacturing.
- Is the issue price for each obligation in the issue at least 95% of its stated redemption price at maturity? Bonds in the issue that are identical (same maturity, payment dates interest rate and issue price), comprise one obligation.
- Do any obligations in the issue have interest rates that increase over the term of the obligation ("stepped-coupon" bonds)? Increases in interest rates that may occur due to indexing to items outside the control of the issuer and bond holders are not considered to be stepped coupon bonds.
- the answer to #2 is yes, and the answer to #3 is no, there are no imputed proceeds in the issue.
B. If there are imputed proceeds in the issue, calculate the amount of imputed proceeds for each obligation in the issue for each bond year over the term of the issue, and aggregate to determine the total imputed proceeds.
- Exclude from the analysis any obligation in the issue that has an issue price of at least 95% of its stated redemption price at maturity and that does not have a stepped coupon.
- For each year over the term of the issue, determine the amount of interest that would accrue on each obligation in the issue that is not excluded pursuant to #1. The interest that will accrue on an obligation during the year is determined using the yield on the obligation, applied at the beginning of the year to an amount equal to the sum of (a) the issue price for the obligation plus (b) the excess of all interest that accrued on the obligation in prior bond years over the amount of interest that was payable with respect to the obligation in prior years. For this purpose, treat any interest paid within the first 30 days of a bond year as if it was paid in the prior bond year.
- Subtract the amount of principal and interest paid on the obligation during the bond year (with the 30 day year end adjustment described in #2) from the amount of interest accruing on the obligation during the bond year, as determined in #2. Treat any negative results as equal to $0.
- Add the results from #3 for all obligations in the issue that are not excluded pursuant to #1 to determine the amount of imputed proceeds on the issue for that bond year.
- Aggregate the amount of imputed proceeds on the issue for all bond years. This is the amount of imputed proceeds on the issue.
C. Add the imputed proceeds to the proceeds of the issue defined in Treasury Regulation Section 1.141-1(b). The resulting sum is the amount used to determine compliance with the 95% expenditure requirement of Sections 142(a) and 144(a).
1After December 31, 1986, except for refunding bonds, such small issue bonds only qualify if 95% of the net proceeds are to be used to provide a manufacturing facility or land for first time farmers.