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 Treasury 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 "IRC") 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.
IRC 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 IRC Section 141(e)(1) provides that exempt facility bonds described in IRC Section142 and qualified small issue bonds described in IRC Section 144(a) are qualified private activity bonds eligible for tax-exemption, use of the definitions related to “proceeds” found in IRC Section 141 are applicable to determine "proceeds" and “net 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 IRC 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 IRC Sections 103 and 103A are divided, by topic, into 11 IRC 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 IRC during the project period (see Treasury Regulation Section 1.141-1(b) definitions of “proceeds” and “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 more than the amounts payable on the issue. 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 was withdrawn in connection with promulgation of regulations under IRC Section 148. Today, Treasury Regulation Section 1.103-8(a)(6) should be applied by using the yield on an obligation determined under Treasury Regulation Section 1.148-4(b), but computed with annual compounding.
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.
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.