IRS WILL NOT RULE ON WHETHER TEMPORARY PERIOD EXTENSIONS FOR ARBITRAGED TAX-EXEMPT BONDS CAUSE 'ARBITRAGE BOND' FINDING.

Rev. Proc. 89-5

SECTION 1. PURPOSE

This revenue procedure provides that, in general, the Internal Revenue Service will not issue rulings to persons that wish to extend the temporary period during which the proceeds of certain state and local bonds are arbitraged and are seeking rulings that the extension will not cause the bonds to be taxable "arbitrage bonds" within the meaning of former section 103(c)(2) of the Internal Revenue Code. In addition, however, this procedure describes a class of situations in which such rulings may be issued (see section 5), and it prescribes the information that must be submitted as part of any request for such a ruling (see section 6).

SEC. 2. BACKGROUND

01 Under former section 103(c)(1) of the Code a bond is an arbitrage bond, and thus interest paid thereon is not tax-exempt, if a major portion of the proceeds of the issue is invested in taxable obligations or securities with a yield that is materially higher than the yield on the governmental obligation (that is, the bond proceeds are arbitraged). However, under former section 103(c)(4)(A) of the Code and section 1.103-14(b) of the Income Tax Regulations, an issuer could arbitrage proceeds of a non-refunding bond for a temporary period prior to their expenditure for the governmental purpose of the issue if certain requirements are met. One of these requirements is that an amount equal to 85 percent of the spendable proceeds of the issue be spent by the end of the three-year period following issuance of the bonds. In the case of certain construction issues, a five-year period may be used if the issuer, by means of a certification of an independent architect or engineer, establishes that a longer period not exceeding five years is needed to expend 85 percent of the spendable proceeds. Sections 1.103-13(a)(2)(ii)(E) and 1.103- 14(b)(5)(ii) of the regulations.

02 The exception for temporary period investment, however, is not available if the issuer (or another party with a material financial interest in the issuance of the bonds) deliberately acts to prolong the period between issuance of the bonds and expenditure of the proceeds by issuing (or having the issuer issue) the bonds prematurely. Rev. Rul. 80-204, 1980-2 C.B. 51. Similarly, the exception for temporary period investment is not available if bonds are issued prematurely to avoid requirements of new federal, state, or local laws, to earn additional arbitrage profits, or for other reasons not consistent with ordinary financial practice.

03 Depending on the particular circumstances, the foregoing restrictions are of practical importance primarily for bonds that were issued before January 1, 1985, January 1, 1986, or September 1, 1986, which were the effective dates for former section 103(c)(6) of the Code and section 148(f).

SEC. 3. SCOPE

This revenue procedure applies to requests that the Service issue a ruling or determination letter concluding that a state or local governmental obligation is not an arbitrage bond solely by reason of the investment of the bond proceeds in acquired nonpurpose obligations at a materially higher yield more than three years after issuance of the bonds, or five years after issuance of the bonds in the case of a construction issue described in section 1.103- 13(a)(2)(ii)(E) of the regulations.

SEC. 4. PROCEDURE

01 The Service will not issue a ruling described in section 3 unless the bonds meet the requirements in section 5.

02 Any request for a ruling to which this revenue procedure applies, in addition to meeting all other applicable requirements, must contain the information described in section 6.

SEC. 5. REQUIREMENTS

01 A bond issue meets the requirements of this section if the following circumstances apply:

(1) The proceeds of the issue of which the bonds are a part were expected as of the date of issue to be used to finance a construction project. An issue of bonds does not fail the requirements of this paragraph merely because an amount of original proceeds of the issue not exceeding 40 percent of the net original proceeds was expected to be used for the acquisition of land or equipment that is directly related and integral to the operation of the buildings or structures that are part of the construction project. For purposes of this revenue procedure, net original proceeds are original proceeds as defined in section 1.103-13(b)(2)(i) of the regulations, minus amounts deposited in a reasonably required reserve or replacement fund as defined in section 1.103-14(d).

(2) By the end of the three-year period, an amount of original proceeds equal to more than 15 percent of the net original proceeds of the issue of bonds was spent for costs relating to construction of the project (including acquisition of any land and equipment described in paragraph (1)). If the bonds are part of a construction issue described in section 1.103-13(a)(2)(ii)(E) of the regulations, the preceding sentence shall be applied by substituting "five-year period" for "three-year period" and "25 percent" for "15 percent." For purposes of this paragraph, expenditures of bond proceeds are considered made first from investment earnings (earnings from investments in both acquired nonpurpose obligations and tax-exempt bonds) and then from original proceeds.

(3) By the end of the applicable three-year or five-year period, an amount of original proceeds equal to more than 5 percent of the net original proceeds of the issue of bonds was spent for direct costs of labor, equipment, and materials used on the construction site (for example, the cost of site preparation or foundation construction but not capitalized interest).

(4) The failure to expend 85 percent of the spendable proceeds by the end of the applicable three-year or five-year period was caused by events that were not reasonably anticipated at the time of issue and were beyond the control of the governmental issuer or true obligor on the bonds.

(5) Due diligence was exercised and will continue to be exercised in expending the proceeds of the bonds in a manner consistent with the intended purpose of the financing. To meet the condition imposed by this paragraph, there must be established with reasonable certainty a specific reasonable date by which all bond proceeds, other than a minor portion, will be expended in a manner consistent with the intended purpose of the bonds. If the issuer or true obligor proposes to invest the bond proceeds in materially higher yielding acquired nonpurpose obligations for a period of more than tree years after the end of the original applicable three-year or five-year period, then there is a rebuttable presumption that the issuer or true obligor will take deliberate and intentional actions to produce arbitrage within the meaning of Rev. Rul. 80-91, 1980-1 C.B. 30, Rev. Rul. 80-92, 1980-1 C.B. 31, and Rev. Rul. 80-188, 1980- 2 C.B. 47.

(6) If bonds are to be secured, directly or indirectly, primarily by revenues from the project being financed with bond proceeds and, pending generation of such revenues, the bond proceeds, directly or indirectly, provide part or all of the security for the bonds, then the bonds must satisfy the following additional conditions:

(a) Within six months after issuance of the bonds, the governmental issueer or true obligor on the bonds entered into a binding contract to incur expenditures that exceeded 10 percent of the cost of construction of the project to be financed with proceeds of the issue of bonds.

(b) Construction of the project commenced within one year after issuance of the issue of bonds. Construction commences when physical work on the project begins.

02 For purposes of section 5, if original proceeds were used to make prepayments prior to the time when payment is customary, then those prepayments are not considered spent prior to that customary time.

03 If an issue of bonds finances more than one project, then the portion of the proceeds being used to finance each such project shall be treated as a separate issue of bonds for purposes of applying the requirements of paragraphs (1), (2), (3), (5), and (6) of section 5.01. If any project fails to meet the requirements as so applied, then no ruling will be issued with respect to the entire issue of bonds. Whether a bond issue finances more than one project will be determined on a case by case basis. This determination shall be made with reference to factors such as whether the buildings and structures were expected to be (a) used as part of an integrated operation, (b) owned and operated by the same person, (c) located on a single or contiguous parcel(s) of land, and (d) placed in service for federal income tax purposes within 12 months of one another.

SEC. 6. REQUIRED INFORMATION

01 Any request for a ruling described in section 3 of this revenue procedure, must (a) meet the requirements of Rev. Proc. 88-33, 1988-25 I.R.B. 48, (b) meet the requirements of any other revenue procedures that relate to submission to the Service of requests for rulings, for example, Rev. Proc. 89-1, and (c) contain all of the information specified in subsection .02.

02 The information specified in this subsection is:

(1) Copies of studies discussing the feasibility of the project, the economic viability of the project, the feasibility of the plan of bond financing, and other similar matters.

(2) A copy of the final official statement that was prepared in connection with the issuance of the bonds.

(3) A copy of the certificate as to arbitrage that was prepared in connection with the issuance of the bonds.

(4) A description of the acquired nonpurpose obligations that were purchased with the original and investment proceeds of the bonds, including the yield on such obligations.

(5) The yield on the governmental obligations, determined on the basis of the issue price within the meaning of sections 1273 and 1274 of the Code.

(6) A statement setting forth (a) the gross amount earned on investment of the original proceeds of the bonds and the investment of such earnings during each year of the applicable three-year or five-year period and (b) the principal and interest paid on the bonds during each year of such three-year or five-year period.

(7) A list detailing the type and amount of costs of issuance of the bonds, including underwriters' discount.

(8) Copies of the original construction and expenditure schedule for the project and the current construction and expenditure schedule for the project.

SEC. 7. MODIFICATION OF REV. PROC. 89-3

This revenue procedure modifies section 4.01 of Rev. Proc. 89-3, 1989-1 I.R.B. ___, relating to areas in which rulings or determination letters will not ordinarily be issued, by adding the following new paragraph:

Section 103. -- Interest on Certain Governmental Obligations. -- Whether a state or local governmental obligation that does not meet the criteria of section 5 of Rev. Proc. 89-5 is an "arbitrage bond" within the meaning of former section 103(c)(2) of the Code solely by reason of the investment of the bond proceeds in acquired nonpurpose obligations at a materially higher yield more than three years after issuance of the bonds or five years after issuance of the bonds in the case of construction issues described in section 1.103- 13(a)(2)(ii)(E) of the regulations.

SEC. 8. EFFECT ON OTHER REVENUE PROCEDURES

Rev. Proc. 89-3 is modified.

SEC. 9. EFFECTIVE DATE

This revenue procedure is effective with respect to any ruling requests currently under consideration by the Service and ruling requests received after this time.

DRAFTING INFORMATION

The principal author of this revenue procedure is Gene Overton of the Office of the Assistant Chief Counsel (Financial Institutions & Products). For further information regarding this revenue procedure contact Mr. Overton on (202) 566-4310 or Mr. James Gibbons on (202) 566-3936 (not toll-free calls).