[Federal Register Volume 63, Number 4 (Wednesday, January 7, 1998)]
[Rules and Regulations]
[Pages 671-673]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-21]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8755]
RIN 1545-AV74


Qualified Zone Academy Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations relating to the 
federal income tax treatment of qualified zone academy bonds. The 
regulations in this document provide needed guidance to holders and 
issuers of qualified zone academy bonds. The text of the temporary 
regulations also serves as the text of the proposed regulations set 
forth in the notice of proposed rulemaking on this subject in the 
Proposed Rules section of this issue of the Federal Register.

DATES: These regulations are effective January 1, 1998.

FOR FURTHER INFORMATION CONTACT: Timothy L. Jones, (202) 622-3980 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Section 226(a) of the Taxpayer Relief Act of 1997, Pub. L. No. 105-
34, 111 Stat. 788 (1997), amended the Internal Revenue Code (Code) by 
redesignating section 1397E as section 1397F and adding a new section 
1397E. Section 1397E authorizes a new type of debt instrument known as 
a qualified zone academy bond.

Explanation of Provisions

In General

    A qualified zone academy bond is a taxable bond issued by a state 
or local government the proceeds of which are used to improve certain 
eligible public schools. In lieu of receiving periodic interest 
payments from the issuer, an eligible holder of a qualified zone 
academy bond is generally allowed annual federal income tax credits 
while the bond is outstanding. These credits compensate the holder for 
lending money to the issuer and function as payments of interest on the 
bond.
    These temporary regulations provide rules for the federal income 
tax treatment of qualified zone academy bonds. These regulations 
generally treat the allowance of the credit as if it were a payment of 
interest on the bond. These regulations also provide rules to determine 
(1) the credit rate, (2) the discount rate used to present value 
private business contributions, and (3) the discount rate used to 
determine the maximum term of a qualified zone academy bond.
    These regulations generally do not provide guidance on the 
statutory requirements that must be met for a bond to qualify as a 
qualified zone academy bond. Section 1397E(d) sets forth a number of 
detailed requirements that must be met for a bond to qualify

[[Page 672]]

as a qualified zone academy bond. In particular, section 1397E(d)(1)(C) 
requires the issuer to certify (1) that it has written assurances that 
private entities have agreed to contribute a certain level of goods or 
services to the qualified zone academy, and (2) that it has the written 
approval of the eligible local education agency for the bond issuance. 
The Treasury and the IRS intend that these certifications will be 
respected and may be relied on by taxpayers if the certifications are 
reasonably made.
    In addition, section 1397E(d)(1)(A) requires that 95 percent or 
more of the proceeds of an issue of qualified zone academy bonds are to 
be used for a qualified purpose described in section 1397E(d)(5) with 
respect to a qualified zone academy as defined in section 1397E(d)(4). 
The Treasury and the IRS intend that the qualified purposes set forth 
in section 1397E(d)(5) are to be broadly interpreted. The Treasury and 
the IRS also intend that, if an issuer is unable to actually spend 95 
percent or more of the proceeds of a qualified zone academy bond for a 
qualified purpose, the issuer may apply remedial actions similar to the 
remedial actions set forth in Sec. 1.142-2 to preserve the 
qualification of a bond. Further, the Treasury and the IRS intend that 
taxpayers may rely on an issuer's determination that a public school 
(or academic program within a public school) is a qualified zone 
academy for purposes of section 1397E(d)(4) if the determination has a 
reasonable basis. The Treasury and IRS request comments on whether 
additional guidance is needed with respect to the section 1397E(d) 
requirements.
    Section 1397E(e) imposes a national limitation on the amount of 
qualified zone academy bonds that can be issued. For 1998 and 1999, the 
IRS will publish a revenue procedure allocating the national limitation 
among the States and the possessions.

The Credit Allowance

    A qualified zone academy bond provides an annual federal income tax 
credit to certain holders. Under the regulations, the credit is deemed 
paid on the credit allowance date--the last day of each one-year 
accrual period on the bond. A taxpayer that receives a credit on a 
credit allowance date may use the credit to offset its income tax 
liability for the taxable year that includes the credit allowance date.
    There are two limitations on the use of the credit. First, only 
eligible taxpayers holding the bond on the credit allowance date may 
claim the credit. Section 1397E(d)(6) defines an eligible taxpayer as a 
bank, an insurance company, or a corporation actively engaged in the 
business of lending money. Second, an eligible taxpayer may claim the 
credit only to the extent the taxpayer has a tax liability for the 
taxable year that includes the credit allowance date. See section 
1397E(c). The credit is nonrefundable.

Treatment of the Credit as Interest

    The regulations treat the credit on a qualified academy zone bond 
as if it were a payment of qualified stated interest. This treatment 
effectively conforms the treatment of the credit with the treatment of 
interest income on debt instruments. Thus, for example, a holder that 
uses an accrual method of accounting accrues the credit amount over the 
one-year accrual period that ends on the credit allowance date.

Adjustment When Credit is Limited or Disallowed

    In two situations the holder of a qualified zone academy bond on a 
credit allowance date will not be able to use some or all of the credit 
to offset its tax liability. First, if the holder on a credit allowance 
date is not an eligible taxpayer (a bank, insurance company, or 
corporation actively engaged in the business of lending money), no 
credit is allowed. Second, the amount of the credit may exceed the 
income tax liability of a holder that is an eligible taxpayer. In this 
second case, because the credit is nonrefundable, some or all of the 
credit will not be used.
    In these situations, the regulations allow the holder to adjust its 
income by deducting the amount of the unused credit. This deduction is 
allowed for the taxable year that includes the credit allowance date. 
The Treasury and the IRS request comments on whether this adjustment 
works appropriately when an eligible taxpayer holds a qualified zone 
academy bond on the credit allowance date but has an income tax 
liability (determined without regard to the credit) that is less than 
the amount of the credit.

Credit Rate

    Section 1397E(b)(2) authorizes the Treasury to establish a single, 
uniform credit rate that will permit the issuance of qualified zone 
academy bonds without discount and without interest cost to the issuer. 
This section also requires the Treasury to adjust the credit allowance 
rate on a monthly basis to reflect changes in market interest rates.
    It is not possible to determine a uniform credit rate that would 
permit all qualified zone academy bonds to be issued at par. Some 
borrowers are less creditworthy than others and, therefore, borrow at 
less favorable rates. In addition, because section 1397E(b)(2) requires 
the Secretary to set the credit rate in the month before the bond is 
issued, changes in market interest rates between the time the rate is 
set and the time a qualified zone academy bond is issued can result in 
a bond being issued at a price that is different than par.
    The regulations provide a single monthly rate that will minimize 
the discount or premium on qualified zone academy bonds. Specifically, 
the regulations provide that the credit rate is 110 percent of the 
long-term applicable Federal rate (AFR), compounded annually, for the 
month of issuance. Tying the credit rate to the AFR ensures that the 
rate will be adjusted on a monthly basis to reflect changes in market 
interest rates. In addition, the Treasury and the IRS believe the 10 
percent spread over the long-term AFR is appropriate, in part, because 
qualified zone academy bonds bear more credit and liquidity risk than 
long-term Treasury bonds.

Maximum Term

    Section 1397E(d)(3) sets out a formula for determining the maximum 
term of a qualified zone academy bond. The formula requires the use of 
a discount rate equal to the average annual interest rate of tax-exempt 
obligations having a term of ten years or more. Because there is no 
readily available source for this discount rate, the regulations 
provide that the discount rate is 110 percent of the long-term adjusted 
AFR, compounded semi-annually. The long-term adjusted AFR is published 
on a monthly basis and is designed to reflect the current yield of a 
risk-free tax-exempt obligation having a term of 9 years or more.

Taxable Obligation

    It is possible that some qualified zone academy bonds may either 
(1) provide for payments of stated interest, or (2) be issued at a 
discount. The Treasury and the IRS have determined that qualified zone 
academy bonds are not obligations the interest on which is excluded 
from gross income under section 103(a). There are a number of reasons 
for treating a qualified zone academy bond as a taxable obligation. For 
example, the requirement in section 1397E(g) that a holder include the 
allowed amount of the credit in gross income evidences an intention to 
treat qualified zone academy bonds as taxable, not tax-exempt, 
obligations.

[[Page 673]]

Coordination With Estimated Tax Rules

    The regulations do not address the estimated tax consequences of 
holding a qualified zone academy bond. The Treasury and the IRS request 
comments on whether there is a need to coordinate the regulations with 
the estimated tax rules and, if so, how they might be coordinated.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations and, because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Internal Revenue Code, these temporary 
regulations will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on their impact on small 
business.

Drafting Information

    Several persons from the Office of Chief Counsel and the Treasury 
Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
adding an entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.1397E-1T also issued under 26 U.S.C. 1397E(b) and 
1397E(d). * * *
    Par. 2. Section 1.1397E-1T is added to read as follows:


Sec. 1.1397E-1T  Qualified zone academy bonds (temporary).

    (a) Overview. In general, a qualified zone academy bond is a 
taxable bond issued by a state or local government the proceeds of 
which are used to improve certain eligible public schools. An eligible 
taxpayer that holds a qualified zone academy bond generally is allowed 
annual federal income tax credits in lieu of periodic interest 
payments. These credits compensate the eligible taxpayer for lending 
money to the issuer and function as payments of interest on the bond. 
Accordingly, this section generally treats the allowance of a credit as 
if it were a payment of interest on the bond. In addition, this section 
provides rules to determine the credit rate, the present value of 
qualified contributions from private entities, and the maximum term of 
a qualified zone academy bond.
    (b) Credit rate. The credit rate for a qualified zone academy bond 
is equal to 110 percent of the long-term applicable Federal rate (AFR), 
compounded annually, for the month in which the bond is issued. The 
Internal Revenue Service publishes this figure each month in a revenue 
ruling that is published in the Internal Revenue Bulletin. See 
Sec. 601.601(d)(2)(ii)(b) of this Chapter.
    (c) Private business contribution requirement. To determine the 
present value (as of the issue date) of qualified contributions from 
private entities under section 1397E(d)(2), the issuer must use a 
reasonable discount rate. The credit rate determined under paragraph 
(b) of this section is a reasonable discount rate.
    (d) Maximum term. The maximum term for a qualified zone academy 
bond is determined under section 1397E(d)(3) by using a discount rate 
equal to 110 percent of the long-term adjusted AFR, compounded semi-
annually, for the month in which the bond is issued. The Internal 
Revenue Service publishes this figure each month in a revenue ruling 
that is published in the Internal Revenue Bulletin. See 
Sec. 601.601(d)(2)(ii)(b) of this Chapter.
    (e) Tax credit--(1) Eligible taxpayer. An eligible taxpayer (within 
the meaning of section 1397E(d)(6)) that holds a qualified zone academy 
bond on a credit allowance date is allowed a tax credit against the 
federal income tax imposed on the taxpayer for the taxable year that 
includes the credit allowance date. The amount of the credit is equal 
to the product of the credit rate and the outstanding principal amount 
of the bond on the credit allowance date. The credit is subject to a 
limitation based on the eligible taxpayer s income tax liability. See 
section 1397E(c).
    (2) Ineligible taxpayer. A taxpayer that is not an eligible 
taxpayer is not allowed a credit.
    (f) Treatment of the allowance of the credit as a payment of 
interest--(1) General rule. The holder of a qualified zone academy bond 
must treat the bond as if it pays qualified stated interest (within the 
meaning of Sec. 1.1273-1(c)) on each credit allowance date. The amount 
of the deemed payment of interest on each credit allowance date is 
equal to the product of the credit rate and the outstanding principal 
amount of the bond on that date. Thus, for example, if the holder uses 
an accrual method of accounting, the holder must accrue as interest 
income the amount of the credit over the one-year accrual period that 
ends on the credit allowance date.
    (2) Adjustment if the holder cannot use the credit to offset a tax 
liability. If a holder holds a qualified zone academy bond on the 
credit allowance date but cannot use all or a portion of the credit to 
reduce its income tax liability (for example, because the holder is not 
an eligible taxpayer or because the limitation in section 1397E(c) 
applies), the holder is allowed a deduction for the taxable year that 
includes the credit allowance date. The amount of the deduction is 
equal to the amount of the unused credit deemed paid on the credit 
allowance date.
    (g) Not a tax-exempt obligation. A qualified zone academy bond is 
not an obligation the interest on which is excluded from gross income 
under section 103(a).
    (h) Cross-references. See section 171 and the regulations 
thereunder for rules relating to amortizable bond premium. See 
Sec. 1.61-7(c) for the seller s treatment of a bond sold between 
interest payment dates (credit allowance dates) and Sec. 1.61-7(d) for 
the buyer s treatment of a bond purchased between interest payment 
dates (credit allowance dates).
    (i) [Reserved]
    (j) Effective date. This section applies to a qualified zone 
academy bond issued on or after January 1, 1998.

Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
    Approved: December 19, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 98-21 Filed 1-6-98; 8:45 am]
BILLING CODE 4830-01-U