Computing Yield on Qualified Student Loan Bonds -- Final Regulations Under Section 148

 CC:FI-80-86                                                                                                [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to arbitrage restrictions on qualified student loan bonds. Changes to the applicable law were made by the Tax Reform Act of 1984 and the Tax Reform Act of 1986. The regulations provide guidance on how to compute the yield on student loans.

 DATES: The regulations are effective for qualified student loan bonds issued after January 5, 1990.

 FOR FURTHER INFORMATION CONTACT: George F. Delduke, 202-566-4545 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document amends the Income Tax Regulations (26 CFR Part 1) to provide rules under section 148 of the Internal Revenue Code relating to arbitrage restrictions on qualified student loan bonds. On July 5, 1989, the Federal Register published proposed amendments (54 FR 28075) to the Income Tax Regulations. This document adopts final regulations based on the notice of proposed rulemaking published on July 5, 1989.

 Twenty-seven written comments responding to the notice of proposed rulemaking were received. In addition, seven persons provided oral comments at a public hearing held on December 13, 1989. After Treasury and Service consideration of all the comments received, the proposed amendments are adopted as revised by this Treasury decision.

PUBLIC COMMENTS

 Several commentators disagreed with the treatment in the proposed regulations of special allowance payments made by the Secretary of Education pursuant to section 438 of the Higher Education Act of 1965. The proposed regulations provided that these payments were to be taken into account in determining the yield on guaranteed student loans.

 Section 625 of the Tax Reform Act of 1984 (98 Stat. 924) provides that the Treasury Department shall prescribe regulations that specify the circumstances under which a qualified student loan bond shall be treated as an arbitrage bond and that these regulations may require special allowance payments to be taken into account in determining yields on student loan notes. (notwithstanding the special rule in former section 103(c)(5) that provided the contrary). In section 1301 of the Tax Reform Act of 1986 (100 Stat. 2602), Congress eliminated the special rule of former section 103(c)(5) and added section 148(g) to the Code, which provides that, except to the extent otherwise provided in regulations, special allowance payments are not to be taken into account in determining yields on student loan notes for purposes of section 148(a)(1). Section 5052 of the Technical and Miscellaneous Revenue Act of 1988 (102 Stat. 3677) provides that if the Treasury Department fails to exercise its regulatory authority under section 625 of the Tax Reform Act of 1984 and section 148(g) of the Code by July 1, 1989, it must report to Congress the reasons for not doing so. Through this series of enactments, Congress in effect required the Treasury Department to exercise its regulatory authority to include special allowance payments in the computation of yield on student loan notes or explain its failure to do so. After review of the Congressional Budget Office ("CBO") study discussed below and all the comments received, the final regulations adopt the rule of the proposed regulations requiring the inclusion of special allowance payments in the computation of yield on student loan notes.

 Section 1.103-13(b)(5)(viii) provides that the yield on a student loan that is treated as an acquired program obligation is materially higher than the yield on an issue if the yield on the obligation exceeds the yield on the issue by more than one and one- half percentage points. The proposed regulations increased the permissible arbitrage spread on student loans from one and one-half percentage points to two percentage points to reflect the higher costs of administering student loan programs relative to most other loan programs. Notwithstanding this increase in the permissible spread, some commentators stated that the spread was still insufficient to cover issuance, servicing, and administrative costs associated with student loans.

 After having studied a 1986 report issued by the CBO, the Treasury Department and the Service have concluded that an arbitrage spread of two percentage points is sufficient to cover the costs of administering most student loan programs. See generally Congressional Budget Office, "The Tax-Exempt Financing of Student Loans" 55-56 (Aug. 1986). However, the commentators argued that the study is based on statistical data that is several years old and, therefore, does not reflect the realities of current market conditions.

 The final regulations adopt the increase in the permissible arbitrage spread from one and one-half to two percentage points provided under the proposed regulations. The increase in the permissible arbitrage spread to two percentage points is based on the CBO study, the only reliable information available to the Service on this issue. Several commentators stated that an independent study concerning costs of administering student loan programs has been commissioned by certain industry groups and that the study will be based on more accurate data than that relied upon in the CBO study. The Service understands that the results of this study will not be available in the near future. The Service welcomes the opportunity to review any data relating to this issue and may reconsider the sufficiency of the two-percentage-point permissible arbitrage spread.

 The final regulations adopt the rule of the proposed regulations, under which the yield on a student loan may be increased to a level sufficient to cover all necessary expenses allocable to the loan. Thus, if the two-percentage-point arbitrage spread is insufficient to cover the amount of necessary expenses allocable to the loan, an issuer may substitute that larger amount in lieu of two percentage points. Although commentators stated that allocating expenses to loans may be burdensome, the Service has received no specific comments on difficulties that may arise in this regard. The Service welcomes comments on this issue.

 In response to several comments, the final regulations clarify that issuers continue to have the option of treating student loans as nonprogram, acquired purpose obligations, which are subject to a one- eighth-of-one-percentage-point arbitrage spread under section 1.103-13(b)(5)(i). The final regulations also clarify that "administrative costs" include (as under section 1.103-13(c)(5)(iv)) the underwriter's spread and the cost of purchasing, carrying, and selling or redeeming student loans.

 In response to many comments, proposed and temporary regulations are being published in this issue of the Federal Register setting forth procedures under which issuers may be permitted to comply with the arbitrage yield limitations on student loans by paying to the United States any amounts necessary to reduce the yield on these loans to a yield that is not materially higher than the yield on the issue. Because proposed and temporary regulations address this issue, section 1.148-10(b)(2)(ii) of the proposed regulations is not included in the final regulations.

EFFECTIVE DATE

 The regulations are generally effective for qualified student loan bonds issued after January 5, 1990. The regulations do not apply to a bond issued exclusively to refund a qualified student loan bond if (1) the refunded bond was issued before January 5, 1990, (2) the amount of the refunding bond does not exceed 101 percent of the amount of the refunded bond, and (3) the maturity date of the refunding bond is not later than the date 17 years after the date of issue of the refunded bond (or, in the case of a series of refundings, the date of issue of the original bond).

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553 (b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805 (f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 These regulations were drafted in the Office of Tax Legislative Counsel, Department of the Treasury, and in the Office of Assistant Chief Counsel (Financial Institutions & Products), Internal Revenue Service. However, personnel from other offices of the Treasury Department and the Internal Revenue Service participated in their development.

LIST OF SUBJECTS

26 CFR 1.61-1.281-4

 Income taxes, Taxable income, Deductions, Exemptions.

Treasury Decision 8284

ADOPTION OF AMENDMENTS TO THE REGULATIONS

The amendments to 26 CFR Part 1 are as follows:

PART 1 -- [AMENDED]

Paragraph 1. The authority for Part 1 is amended by adding the following citation:

Authority: 26 U.S.C. 7805. * * * Section 1.148-10 also issued under 26 U.S.C. 148(g) and (i) and 98 Stat. 924.

Par. 2. The following new section 1.148-10 is added in the appropriate place:

SECTION 1.148-10 PURPOSE INVESTMENTS.

(a) GENERAL RULE. [Reserved]

(b) SPECIAL RULES FOR STUDENT LOANS -- (1) PROGRAM LOANS -- (i) MATERIALLY HIGHER. The yield on student loans that are treated as acquired program obligation within the meaning of section 1.103-13(h) (rather than as nonprogram, acquired purpose obligations for purposes of section 1.103-13(b)(5)(i)) and are allocated to the proceeds of an issue is not materially higher than the yield on the issue if the yield on the student loans does not exceed the yield on the issue by more than two percentage points. In lieu of the amount described in the preceding sentence, the issuer may substitute such larger amount as is necessary to pay expenses (including losses resulting from bad debts) reasonably expected to be incurred as a direct result of administering the student loan program to the extent that those expenses are not payable with funds appropriated from other sources.

(ii) ADMINISTRATIVE COSTS. For purposes of determining the yield on student loans under paragraph (b)(l)(i) of this section, administrative costs (within the meaning of section 1.103-13(c)(5)(iv)) that are paid by the obligors are not taken into account. The preceding sentence applies whether or not the payments are made from proceeds of the issue and whether or not the payments are treated as reimbursements of administrative costs, provided that the present value of the payments does not exceed the present value of the administrative costs paid by the issuer. This paragraph (b)(1)(ii) does not apply to any amount taken into account in computing the yield on the issue.

(2) SPECIAL ALLOWANCE PAYMENTS. Payments made by the Secretary of Education pursuant to section 438 of the Higher Education Act of 1965 are taken into account in determining the yield on student loans.

(3) EFFECTIVE DATE. This paragraph (b) applies to any bond issued after January 5, 1990, except --

(i) A bond issued exclusively to refund a bond issued before that date if --

(A) The amount of the refunding bond does not exceed 101 percent of the amount of the refunded bond; and

(B) The maturity date of the refunding bond is not later than the date that is 17 years after the date on which the refund bond was issued (or, in the case of a series of refundings, the date on which the original bond was issued); and

(ii) A qualified student loan bond described in section 144(b)(1)(A) needed to fulfill binding written commitments to acquire or finance student loans originated before such date and after June 30, 1984, but only if the amount of those commitments is consistent with practices of the issuer that were in effect on March 15, 1984, with respect to establishing secondary markets for student loans described in section 144(b)(1)(A).