Rev. Rul. 80-204

Are the bonds issued by an authority that is a political subdivision of a city subject to the arbitrage yield restrictions of section 103(c) of the Internal Revenue Code with respect to the investment of the bond proceeds under the circumstances described below?

FACTS

On January 1, 1979, Authority M was created as a political subdivision of City O in order to consolidate under one administration the various utilities within O. The first major project that M will undertake is construction of a water distribution facility. Because M has no revenues with which to pay for the construction, M planned to issue bonds for this purpose. Such bonds would not be "industrial development bonds" within the meaning of section 103(b)(2) of the Code.

On September 1, 1979, M incurred a binding obligation to corporation X involving the expenditure of $500,000 for planning and engineering services in connection with the water distribution facility. Because of the nature of the services, X will be unable to complete the planning process before October 1, 1981. It is estimated that construction of the facility will begin in February 1982, and will be completed before August 31, 1982.

In accordance with ordinary financial practice, M would not issue bonds to pay for construction of the facility until the planning process was substantially completed. However, M issued $10,000,000 of 6 percent general obligation bonds on January 2, 1980. From the available bond proceeds of $9,400,000 (face amount minus costs of issuance and a portion of the $500,000 fee for planning and engineering), $8,400,000 was invested in a one-year certificate of deposit at a 12.5 percent interest rate, $500,000 was invested in a six-month certificate at 13 percent, and $500,000 was invested in a nine-month certificate at 12.5 percent.

The stated purpose of the abnormally early issuance is to take advantage of the large interest spread between taxable and tax-exempt obligations in order to generate cash income. The income will be used primarily to pay for the initial administrative costs of establishing M.

LAW AND ANALYSIS

Section 103(a)(1) of the Code provides that gross income does not include interest on obligations of a state or a political subdivision of a state.

Section 103(c)(1) of the Code provides that, with certain minor exceptions, the interest on any arbitrage bond will not be excludable from gross income.

Section 103(c)(2) of the Code provides that the term "arbitrage bond" means any obligation that is issued as part of an issue all or a major portion (more than 15 percent) of the proceeds of which are reasonably expected to be used directly or indirectly (A) to acquire securities or obligations that may be reasonably expected at the time of issuance of such issue, to produce a yield over the term of the issue that is materially higher than the yield on obligations of such issue, or (B) to replace funds that were used directly or indirectly to acquire securities or obligations described in section 103(c)(2)(A).

Section 103(c)(4)(A) of the Code provides that an obligation shall not be treated as an arbitrage bond solely by reason of the fact that the proceeds of the issue of which such obligation is a part may be invested for a temporary period in securities or other obligations until such proceeds are needed for the purpose for which such issue was issued.

Section 1.103-14(b) of the Income Tax Regulations provides in general that original proceeds and investment proceeds of an issue of governmental obligations that are invested in acquired obligations during a 3-year period beginning on the date of issue are invested for a temporary period if the expenditure test of paragraph (b)(2), the time test of paragraph (b)(3), and the due diligence test of paragraph (b)(4) are satisfied. The time test requires that the issuer must incur a substantial binding obligation to commence the project within 6 months after the date of issue. The due diligence test provides that after the substantial binding obligation is incurred, work on the facility must proceed with due diligence to completion. The expenditure test provides that at least 85 percent of spendable proceeds (as defined in paragraph (b)(2)(iii)) must be spent within the temporary period.

When bonds are issued to finance a public project, the due diligence test is ordinarily satisfied whenever the issuer endeavors to spend the bond proceeds on the project with reasonable dispatch. In determining whether due diligence has been exercised, any legal, financial, engineering, or other obstacle to engaging in work on the project will ordinarily be taken into account.

In this case, however, actual construction of the water facility will not begin until more than two years after the date of issue. Moreover, M's purpose in proceeding with the bond issue prematurely was to secure an opportunity to invest the bond proceeds in higher yielding taxable obligations. Thus, M has deliberately acted to prolong the period between issuance of the bonds and expenditure of the proceeds, and has done so for the purpose of earning arbitrage. A deliberate act of this nature is inconsistent with the requirement of due diligence.

In these circumstances, M does not satisfy the due diligence test of section 1.103-14(b)(4) of the regulations. However, this case is distinguishable from one where the date of issuance is determined solely with regard to bona fide financial or other nonarbitrage reasons (for example, where financing for one project is combined with financing for several others solely for economies of scale and other bond marketing advantages).

HOLDING

The bond proceeds do not qualify for investment at a materially higher yield during a temporary period described in section 1.103-14(b) of the regulations. Further, the bonds are arbitrage bonds, and the interest received by the bondholders is not excludable from their gross incomes under section 103(a)(1) of the Code.