[Federal Register Volume 67, Number 74 (Wednesday, April 17, 2002)]
[Proposed Rules]
[Pages 18835-18839]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-9356]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-113526-98; REG-105369-00]
RIN 1545-AW44; 1545-AY12


Arbitrage and Private Activity Restrictions Applicable to Tax-
exempt Bonds Issued by State and Local Governments; Investment-type 
Property (Prepayment); Private Loan (Prepayment)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of previous notice of proposed rulemaking; notice of 
proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments to the final 
regulations on the arbitrage and private activity restrictions 
applicable to tax-exempt bonds issued by State and local governments. 
The proposed amendments affect issuers of tax-exempt bonds and provide 
guidance on the definitions of investment-type property and private 
loan to help issuers comply with the arbitrage and private activity 
restrictions. This document also provides notice of a public hearing on 
these proposed regulations.
    The previous notice of proposed rulemaking (REG-113526-98), 
published on August 25, 1999, relating to arbitrage and related 
restrictions applicable to tax-exempt bonds issued by State and local 
governments, is withdrawn.

DATES: Written or electronic comments must be received by July 16, 
2002. Outlines of topics to be discussed at the public hearing 
scheduled for September 24, 2002, at 10 a.m., must be received by 
September 10, 2002.
    The previous notice of proposed rulemaking (REG-113526-98), 
published on August 25, 1999, relating to arbitrage and related 
restrictions applicable to tax-exempt bonds issued by State and local 
governments, is withdrawn.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-105369-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:ITA:RU (REG-105369-00), courier's desk, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC. 
Alternatively, submissions may be made electronically to the IRS 
Internet site at www.irs.gov/regs. The public hearing will be held in 
the Auditorium, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Johanna Som de Cerff, (202) 622-3980; concerning submissions and the 
hearing, Sonya Cruse, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:   

Background

    This document contains proposed amendments to 26 CFR part 1 (the 
proposed regulations). On August 25, 1999, the IRS published in the 
Federal Register a notice of proposed rulemaking (REG-113526-98) (64 FR 
46320) (the 1999 proposed regulations) proposing to modify Sec. 1.148-
1(e) of the Income Tax Regulations to establish which prepayments for 
property or services give rise to investment-type property under 
section 148(b)(2)(D) of the Internal Revenue Code (Code). Numerous 
written comments responding to the 1999 proposed regulations were 
received, and a public hearing was held on January 12, 2000. In 
response to the extensive comments, particularly with regard to certain 
natural gas prepayment transactions discussed below, the 1999 proposed 
regulations are withdrawn and amendments to Sec. 1.148-1(e) are 
proposed in accordance with this notice of proposed rulemaking. This 
notice of proposed rulemaking also proposes corresponding amendments to 
Sec. 1.141-5(c)(2) (relating to the private loan financing test).

Explanation of Provisions

I. Existing Definition of Investment-type Property

    With certain exceptions, section 148 prohibits the use of proceeds 
of a tax-exempt bond issue to acquire investment property with a yield 
that materially exceeds the yield on the issue. Section 148(b)(2)(D) 
provides that the term investment property includes investment-type 
property. Section 148(b)(2)(D) was added to the Code by the Tax Reform 
Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085 (1986) (1986 Act). The 
Conference Committee Report states that the legislation ``expands the 
types of investments of bond proceeds that are subject to the arbitrage 
restrictions to include all investment-type property (including other 
than customary prepayments) * * *.'' H.R. Conf. Rep. No. 99-841, pt. 2, 
at 745.
    As an economic matter, prepayments for property or services 
generally contain a built-in investment return. That is, if a buyer of 
property or services makes a cash payment to the seller in advance of 
the seller's performance, the buyer may expect to receive an implicit 
investment return based on the time value of money. In the case of a 
prepayment financed with tax-exempt bond proceeds, the presence of a 
built-in investment return raises the issue of whether the prepayment 
gives rise to investment-type property.
    The existing regulations, at Sec. 1.148-1(e)(2), contain rules for 
determining when a prepayment for property or services results in 
investment-type property. Under that provision, a prepayment generally 
gives rise to investment-type property if a principal purpose for 
prepaying is to receive an investment return from the time the 
prepayment is made until the time payment otherwise would be made. 
However, a prepayment does not give rise to investment-type property 
under the existing regulations if (1) it is made

[[Page 18836]]

for a substantial business purpose other than investment return and the 
issuer has no commercially reasonable alternative to the prepayment 
(the business purpose exception); or (2) prepayments on substantially 
the same terms are made by a substantial percentage of persons who are 
similarly situated to the issuer but who are not beneficiaries of tax-
exempt financing (the customary exception).

II. 1999 Proposed Amendments to the Definition of Investment-type 
Property

    The 1999 proposed regulations proposed a modification to 
Sec. 1.148-1(e)(2) to establish that a prepayment of a contract for 
property or services that is made after the date that the contract is 
entered into can give rise to investment-type property. This 
modification was proposed in light of the opinion in City of Columbus 
v. Commissioner, 112 F.3d 1201 (D.C. Cir. 1997), which concluded that a 
1994 prepayment by a city of its indebtedness to a state did not 
constitute a prepayment for property the city acquired in 1967. The 
proposed amendment to Sec. 1.148-1(e)(2) addressed only the narrow 
issue of whether a prepayment for property or services after the 
execution of a contract to buy the property or services can give rise 
to investment-type property.
    Commentators generally agreed with the suggestion that a prepayment 
for property or services can occur after the date the purchase contract 
is executed. The proposed regulations retain the proposed change to 
Sec. 1.148-1(e)(2), with clarifying modifications that are consistent 
with this concept.

III. Definition of Investment-type Property in the Proposed Regulations

    Although commentators generally agreed with the 1999 proposed 
amendments to Sec. 1.148-1(e)(2), they requested additional 
clarification of other aspects of the definition of investment-type 
property. After considering all of the comments, Treasury and the IRS 
have determined that additional changes to the definition are needed to 
provide certainty to issuers and the IRS in a manner that is consistent 
with the broad scope of the investment-type property concept. To allow 
for public comment, these additional changes are issued in proposed 
form. Furthermore, to provide issuers with immediate certainty, issuers 
may rely on the proposed regulations to the extent specified below.
    Commentators generally did not recommend modifying the basic 
framework for determining whether a prepayment gives rise to 
investment-type property under Sec. 1.148-1(e)(2). The proposed 
regulations retain this basic structure, but make certain 
modifications. In particular, the proposed regulations: (1) Amend the 
business purpose exception; (2) retain the customary exception in its 
present form; (3) add an exception for certain prepayments by municipal 
utilities to acquire a supply of natural gas; and (4) add a de minimis 
exception for prepayments made within 90 days of delivery of the 
property or services. In addition, the proposed regulations state that 
the Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment does not give rise to investment-
type property.
A. Business Purpose Exception
    As indicated, the existing regulations provide that a prepayment 
does not give rise to investment-type property if it is made for a 
substantial business purpose other than investment return and the 
issuer has no commercially reasonable alternative to the prepayment. 
This provision, which was intended to be a narrow exception to the 
definition of investment-type property, has raised difficult 
interpretive questions. For example, in many instances it may be 
unclear whether the alternatives available to the issuer are 
``commercially reasonable.''
    Commentators suggested certain changes to the provision to clarify 
its application. For example, they suggested that a prepayment should 
be considered made for a substantial business purpose other than 
investment return if the effect of the prepayment is (1) to fix the 
price of the property or service, (2) to assure a supply of the 
property or service, (3) to guarantee delivery of the property or 
service at a location favorable to the issuer, or (4) to enable the 
issuer to obtain a price discount that materially exceeds the 
investment return that could be earned between the time the prepayment 
is made and the time the property or services are delivered. 
Commentators suggested that an alternative should be viewed as 
``commercially reasonable'' if it is reasonably available to the 
issuer, it would achieve the same substantial business purpose as the 
prepayment except that no investment return is received, and it is not 
more expensive by an amount that materially exceeds the investment 
return from the prepayment. Some commentators recommended that a safe 
harbor be added under which an alternative would not be considered 
commercially reasonable if the cost of the alternative exceeded the 
cost of the prepayment by a specified amount on a present value basis.
    Treasury and the IRS have considered these suggested factors and 
have concluded that they do not, in and of themselves, represent 
administrable standards for distinguishing between prepayments that are 
made primarily for arbitrage purposes and those that are not. That is, 
a prepayment transaction may contain one or more of these features, 
even if it is primarily arbitrage-motivated. Therefore, the proposed 
regulations do not adopt these suggested amendments. Nevertheless, as 
discussed below, these factors are taken into account, together with 
all the other facts and circumstances, in determining whether a 
prepayment satisfies the business purpose exception as revised by the 
proposed regulations.
    In this regard, the proposed regulations amend the business purpose 
exception in order to clarify that it is to be applied narrowly in a 
manner that is consistent with the broad scope of the investment-type 
property concept. In particular, under the proposed regulations a 
prepayment meets the business purpose exception if the facts and 
circumstances clearly establish that the primary purpose for the 
prepayment is to accomplish one or more substantial business purposes 
that (1) are unrelated to any investment return based on the time value 
of money, and (2) cannot be accomplished without the prepayment. This 
exception is intended to be very narrow and to apply only in very 
unique circumstances, such as the situation illustrated by an example 
in the proposed regulations.
B. Customary Exception
    As indicated, the existing regulations provide that a prepayment 
does not give rise to investment-type property if prepayments on 
substantially the same terms are made by a substantial percentage of 
persons who are similarly situated to the issuer but who are not 
beneficiaries of tax-exempt financing. This provision implements the 
legislative history cited above that indicates that customary 
prepayments should not result in investment-type property.
    Commentators suggested that a safe harbor be added for determining 
a ``substantial percentage'' of similarly situated persons. However, 
Treasury and the IRS have concluded that the determination of whether a 
transaction is customary is appropriately made on a case-by-case basis, 
taking into account all the facts and circumstances, rather than by 
reference to a precise mathematical formula or predetermined

[[Page 18837]]

percentage. Therefore, the proposed regulations do not adopt this 
suggested change.
    Commentators also recommended that the ``substantial percentage'' 
requirement should be deemed satisfied if a substantial number of 
similarly situated persons who are not beneficiaries of tax-exempt 
financing make a similarly sized prepayment. The proposed regulations 
do not adopt this comment because the incidence of a particular number 
of transactions by similarly situated persons may not establish that 
the transaction is customary if those persons represent only a small 
percentage of all the similarly situated persons.
    Finally, some commentators suggested that the customary exception 
should be automatically satisfied if the issuer and the supplier of the 
property or services certify reasonably and in good faith that its 
requirements are met. The proposed regulations do not adopt this 
comment because a certification by the parties to a transaction should 
not be sufficient to establish the legal conclusion that the 
transaction meets the requirements of the exception.
C. Certain Prepayments To Acquire a Supply of Natural Gas
    The preamble to the 1999 proposed regulations identified certain 
transactions involving the issuance of bonds to prepay for a supply of 
natural gas and the simultaneous execution by the issuer of a commodity 
swap under which the issuer receives fixed payments and makes variable 
payments based on an index. The 1999 preamble stated that Treasury and 
the IRS were concerned that the transactions create investment-type 
property and requested comments on the transactions.
    Most, but not all, of the commentators disagreed with the 
suggestion that the identified transactions should result in 
investment-type property. They stated that deregulation of the natural 
gas industry has threatened the ability of municipal utilities to 
obtain a secure supply of natural gas on commercially reasonable terms. 
They stated that the natural gas prepayment transactions are necessary 
to obtain a guaranteed supply of natural gas on favorable terms in 
light of deregulation.
    The proposed regulations add an exception to the definition of 
investment-type property for certain natural gas prepayments that are 
made by or for one or more utilities that are owned by a governmental 
person, as defined in Sec. 1.141-1(b) (for example, where a joint 
action agency acquires a natural gas supply for one or more municipal 
gas or electric utilities). The exception applies only if at least 95 
percent of the natural gas purchased with the prepayment is to be 
consumed by retail customers in the service area of a municipal gas 
utility, or used to produce electricity that will be furnished to 
retail customers that a municipal electric utility is obligated to 
serve under state or Federal law. For this purpose, the service area of 
a municipal gas utility is defined as (1) any area throughout which the 
municipal utility provided (at all times during the five-year period 
ending on the issue date) gas transmission or distribution service, and 
any area that is contiguous to such an area, or (2) any area where the 
municipal utility is obligated under state or Federal law to provide 
gas distribution services as provided in such law. Issuers may apply 
principles similar to the rules of Sec. 1.141-12 in order to cure a 
violation of this 95 percent requirement.
    A transaction will not fail to qualify for this exception by reason 
of any commodity swap contract that may be entered into between the 
issuer and an unrelated party (other than the gas supplier), or between 
the gas supplier and an unrelated party (other than the issuer), so 
long as each swap contract is an independent contract. For this 
purpose, a swap contract is an independent contract if the obligation 
of each party to perform under the swap contract is not dependent on 
performance by any person (other than the other party to the swap 
contract) under another contract (for example, a gas supply contract or 
another swap contract).
    Comments are requested on the exception for natural gas prepayments 
in the proposed regulations, including the definition of service area 
and the workability of the 95 percent test.
D. De minimis Prepayments
    Commentators recommended adding to the regulations a de minimis 
exception under which prepayments that are made in small amounts or 
shortly before the property or services are delivered, would be 
disregarded. Treasury and the IRS recognize that prepayments made 
shortly before the property or services are delivered are unlikely to 
be arbitrage-motivated. Based on this consideration, and to provide 
administrative certainty, the proposed regulations add an exception for 
prepayments that are made within 90 days of the date of delivery of the 
property or services. However, the proposed regulations do not provide 
an exception for small prepayments because a prepayment may be made 
primarily for arbitrage purposes even if it is a small amount.
E. Timing Mismatch Between Payment and Delivery of Property or Services
    The preamble to the 1999 proposed regulations requested comments 
regarding the proper treatment of contracts that provide for a timing 
mismatch between the buyer's cash payments and the seller's delivery of 
property or services.
    Commentators generally expressed the view that, depending on the 
particular facts, payments made over time may give rise to investment-
type property when the payment schedule does not match the schedule for 
the provision of property or services. The commentators did not 
recommend any changes to the regulations on this issue. Treasury and 
the IRS have determined that Sec. 1.148-1(e)(2) appropriately addresses 
mismatches in payment and delivery obligations. Therefore, the proposed 
regulations do not propose any amendments in this regard.
F. Prepayments of Capital Charges
    Some commentators recommended that the regulations be modified to 
provide that a prepayment does not give rise to investment-type 
property if it is in substance a reimbursement to a seller of all or a 
portion of the seller's capital costs of a specific, tangible project 
through which the seller produces or delivers a service or commodity. 
The proposed regulations do not contain a specific exception for 
prepayments that reimburse a seller for its capital costs because a 
prepayment may be made primarily for arbitrage purposes even if it 
effectively reimburses the seller for capital costs. Nevertheless, this 
factor is taken into account, together with all the other facts and 
circumstances, in determining whether a prepayment meets the business 
purpose exception.

IV. Private Loans

    With certain exceptions, interest on an issue that meets the 
private loan financing test is not excluded from gross income. Under 
section 141(c), an issue generally meets the private loan financing 
test if more than the lesser of 5 percent or $5 million of its proceeds 
are used to make loans to nongovernmental persons. Section 1.141-
5(c)(1) states that, for purposes of the private loan financing test, a 
loan may arise from the direct lending of bond proceeds or may arise 
from transactions in which indirect benefits that are the economic 
equivalent of a loan are conveyed. Thus, the determination of whether a 
loan is made depends on the substance of a

[[Page 18838]]

transaction rather than its form. See also H.R. Conf. Rep. No. 99-841, 
pt. 2, at 692.
    The existing regulations, at Sec. 1.141-5(c)(2)(ii), provide that a 
prepayment for property or services generally is treated as a loan for 
purposes of the private loan financing test if a principal purpose for 
prepaying is to provide a benefit of tax-exempt financing to the 
seller. However, under the existing regulations a prepayment is not 
treated as a loan for purposes of the private loan financing test if 
(1) it is made for a substantial business purpose other than providing 
a benefit of tax-exempt financing to the seller and the issuer has no 
commercially reasonable alternative to the prepayment; or (2) 
prepayments on substantially the same terms are made by a substantial 
percentage of persons who are similarly situated to the issuer but who 
are not beneficiaries of tax-exempt financing. The proposed regulations 
amend the private loan provisions of Sec. 1.141-5(c)(2) to conform to 
the amendments to the definition of investment-type property in this 
notice of proposed rulemaking.

Proposed Effective Date

    The proposed regulations will apply to bonds sold on or after the 
date of publication of final regulations in the Federal Register. 
However, issuers may apply the proposed regulations in whole, but not 
in part, to any issue that is sold on or after the date the proposed 
regulations are published in the Federal Register and before the 
effective date of the final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedures 
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 Code, this notice of 
proposed rulemaking will be submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments that are submitted 
timely (preferably a signed original and eight copies) to the IRS. The 
Treasury Department and IRS specifically request comments on the 
clarity of the proposed rules and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for September 24, 2002, at 10 
a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the lobby more than 30 minutes before the 
hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written comments by July 16, 2002, and submit an outline of the 
topics to be discussed and the amount of time to be devoted to each 
topic by September 10, 2002.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Rebecca L. Harrigal 
and Johanna Som de Cerff, Office of Chief Counsel (TE/GE), IRS, and 
Stephen J. Watson, Office of Tax Policy, Treasury Department. However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

    Par. 2. In Sec. 1.141-5, paragraph (c) is amended as follows:
    1. Paragraph (c)(2)(ii) introductory text is revised.
    2. Paragraph (c)(2)(ii)(A) is revised.
    3. Paragraph (c)(2)(ii)(B) is amended by removing the period at the 
end of the paragraph and adding a semicolon in its place.
    4. Paragraphs (c)(2)(ii)(C), (c)(2)(ii)(D), and (c)(2)(iii) are 
added.
    The revisions and additions read as follows:


Sec. 1.141-5  Private loan financing test.

* * * * *
    (c) * * *
    (2) * * *
    (ii) Certain prepayments treated as loans. Except as otherwise 
provided, a prepayment for property or services, including a prepayment 
for property or services that is made after the date that the contract 
to buy the property or services is entered into, is treated as a loan 
for purposes of the private loan financing test if a principal purpose 
for prepaying is to provide a benefit of tax-exempt financing to the 
seller. A prepayment is not treated as a loan for purposes of the 
private loan financing test if--
    (A) The primary purpose for the prepayment is to accomplish one or 
more substantial business purposes that--
    (1) Are unrelated to providing any benefit of tax-exempt financing 
to the seller; and
    (2) Cannot be accomplished without the prepayment;
* * * * *
    (C) The prepayment is made within 90 days of the date of delivery 
to the issuer of all of the property or services for which the 
prepayment is made; or
    (D) The prepayment meets the requirements of Sec. 1.148-1(e)(2)(ii) 
(relating to certain prepayments to acquire a supply of natural gas).
    (iii) Additional prepayments as permitted by the Commissioner. The 
Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment is not treated as a loan for 
purposes of the private loan financing test.
* * * * *
    Par. 3. In Sec. 1.148-1, paragraphs (e)(1) and (2) are revised to 
read as follows:


Sec. 1.148-1  Definitions and elections.

* * * * *
    (e) Investment-type property--(1) In general. Investment-type 
property includes any property, other than property described in 
section 148(b)(2)(A), (B), (C) or (E), that is held principally as a 
passive vehicle for the production of income. For this purpose, 
production of income includes any benefit based on the time value of 
money.
    (2) Prepayments--(i) In general. Except as otherwise provided in 
this paragraph (e)(2), a prepayment for property or services, including 
a prepayment for property or services that is made after the date that 
the contract to buy the property or services is

[[Page 18839]]

entered into, also gives rise to investment-type property if a 
principal purpose for prepaying is to receive an investment return from 
the time the prepayment is made until the time payment otherwise would 
be made. A prepayment does not give rise to investment-type property 
if--
    (A) The primary purpose for the prepayment is to accomplish one or 
more substantial business purposes that--
    (1) Are unrelated to any investment return based on the time value 
of money; and
    (2) Cannot be accomplished without the prepayment;
    (B) Prepayments on substantially the same terms are made by a 
substantial percentage of persons who are similarly situated to the 
issuer but who are not beneficiaries of tax-exempt financing;
    (C) The prepayment is made within 90 days of the date of delivery 
to the issuer of all of the property or services for which the 
prepayment is made; or
    (D) The prepayment meets the requirements of paragraph (e)(2)(ii) 
of this section.
    (ii) Certain prepayments to acquire a supply of natural gas.
    (A) In general. A prepayment meets the requirements of this 
paragraph (e)(2)(ii) if--
    (1) It is made by or for one or more utilities that are owned by a 
governmental person, as defined in Sec. 1.141-1(b) (municipal utility), 
to purchase a supply of natural gas; and
    (2) At least 95 percent of the natural gas purchased with the 
prepayment is to be consumed by retail gas customers in the service 
area (as defined in paragraph (e)(2)(ii)(B) of this section) of a 
municipal utility, or used to produce electricity that will be 
furnished to retail electric customers that a municipal utility is 
obligated to serve under state or Federal law. An obligation that 
arises solely by reason of a contract is not an obligation to serve 
under state or Federal law.
    (B) Service area. For purposes of paragraph (e)(2)(ii)(A)(2) of 
this section, the service area of a municipal utility shall consist 
of--
    (1) Any area throughout which the municipal utility provided (at 
all times during the 5-year period ending on the issue date) gas 
transmission or distribution service, and any area that is contiguous 
to such an area; or
    (2) Any area where the municipal utility is obligated under state 
or Federal law to provide gas distribution services as provided in such 
law.
    (C) Commodity swaps. A prepayment does not fail to meet the 
requirements of this paragraph (e)(2)(ii) by reason of any commodity 
swap contract that may be entered into between the issuer and an 
unrelated party (other than the gas supplier), or between the gas 
supplier and an unrelated party (other than the issuer), so long as 
each swap contract is an independent contract. A swap contract is an 
independent contract if the obligation of each party to perform under 
the swap contract is not dependent on performance by any person (other 
than the other party to the swap contract) under another contract (for 
example, a gas supply contract or another swap contract).
    (iii) Additional prepayments as permitted by the Commissioner.
    The Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment does not give rise to investment-
type property.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (e)(2):

    Example 1. Prepayment after contract is executed. In 1998, City 
A enters into a ten-year contract with Company Y. Under the 
contract, Company Y is to provide services to City A over the term 
of the contract and in return City A will pay Company Y for its 
services as they are provided. In 2004, City A issues bonds to 
finance a lump sum payment to Company Y in satisfaction of City A's 
obligation to pay for Company Y's services to be provided over the 
remaining term of the contract. The use of bond proceeds to make the 
lump sum payment constitutes a prepayment for services under 
paragraph (e)(2)(i) of this section, even though the payment is made 
after the date that the contract is executed.
    Example 2. Prepayment necessary to accomplish substantial 
business purpose. Authority is a governmental unit that furnishes 
electricity to the general public. In 1995, Authority enters into a 
15-year agreement (the Agreement) with Power Company to obtain 
certain of its power requirements. In 2003, Authority enters into 
another contract (the Purchase Contract) with Power Company to 
obtain a specified amount of additional firm power through 2013. The 
rates paid by Authority under the Purchase Contract are based on a 
fixed capacity charge, which reflects Power Company's average cost 
of certain plants and equipment, and a variable energy charge, which 
reflects Power Company's average system energy costs to operate the 
utility, primarily fuel costs. Simultaneously with entering into the 
Purchase Contract, Authority issues a $30 million issue with a 6 
percent yield and uses the proceeds to make a lump sum payment to 
Power Company to prepay for the entire fixed capacity charge under 
the Purchase Contract. Authority pays the variable energy charges as 
energy is actually delivered. Power Company reports the lump sum 
payment for Federal tax purposes as income from the sale of 
capacity. Power Company also agrees to certain concessions under the 
Agreement, including the elimination of floors on capacity charges 
and a moratorium on capacity charge increases for five years. The 
discount rate used to compute the amount of the prepayment is 18 
percent, compounded semi-annually. Power Company's taxable borrowing 
rate for a loan of a comparable size to the prepayment, with a term 
that coincides with the term of the Purchase Contract, is 8 percent, 
compounded semiannually. The prepayment allows Power Company to 
offer a low capacity charge to Authority, yet prevent other 
wholesale customers from taking advantage of the proposal. Under 
Federal rate-making guidelines, if Power Company had offered 
Authority a contract based on fixed periodic capacity charges, Power 
Company would have been obligated to offer the same capacity charges 
to its other wholesale customers (which would have been expected to 
accept the offer). Power Company is willing to offer Authority the 
lower capacity charge and to make the other concessions because it 
owns surplus generating capacity. Thus, it is important to Power 
Company to maintain its customer base. The loss of a significant 
customer such as Authority would require that Power Company either 
succeed in obtaining regulatory authorization to increase its rates 
charged to other customers or suffer a diminished return on capital. 
Power Company will not build additional generating facilities 
directly or indirectly by reason of its obligations under the 
Purchase Contract, and at the time it entered into the Purchase 
Contract, it had already incurred capital costs of facilities, 
which, if allocated to Authority's demands for energy under the 
Purchase Contract, would exceed the up-front capacity charge. Under 
paragraph (e)(2)(i)(A) of this section, the prepayment does not give 
rise to investment-type property.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-9356 Filed 4-16-02; 4:12 pm]
BILLING CODE 4830-01-P