[Federal Register Volume 68, Number 149 (Monday, August 4, 2003)]
[Rules and Regulations]
[Pages 45772-45777]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-19644]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9085]
RIN 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: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations on the arbitrage and 
private activity restrictions applicable to tax-exempt bonds issued by 
State and local governments. These regulations 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.

DATES: Effective Date: These regulations are effective October 3, 2003.
    Applicability Date: For dates of applicability, see Sec. Sec.  
1.141-15(b)(3) and 1.148-11(j) of these regulations.

FOR FURTHER INFORMATION CONTACT: Johanna Som de Cerff (202) 622-3980 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document amends the Income Tax Regulations (26 CFR part 1) 
under sections 141 and 148 of the Internal Revenue Code by providing 
rules for determining whether a prepayment for property or services 
results in a private loan or investment-type property (the final 
regulations). On April 17, 2002, the IRS published in the Federal 
Register a notice of proposed rulemaking (REG-113526-98; REG-105369-00) 
(67 FR 18835) (the proposed regulations). The proposed regulations 
modify Sec. Sec.  1.141-5(c)(2) and 1.148-1(e) of the Income Tax 
Regulations to establish which prepayments for property or services 
give rise to a private loan under section 141(c) or investment-type 
property under section 148(b)(2)(D). On September 25, 2002, the IRS 
held a public hearing on the proposed regulations. Written comments 
responding to the proposed regulations were also received. After 
consideration of all the comments, the proposed regulations are adopted 
as amended by this Treasury decision. The revisions are discussed 
below.

Explanation of Provisions

I. Investment-type Property

A. Existing Regulations
    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 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

[[Page 45773]]

percentage of persons who are similarly situated to the issuer but who 
are not beneficiaries of tax-exempt financing (the customary 
exception).
B. Business Purpose Exception
    The proposed regulations narrow the scope of the business purpose 
exception. Under the proposed regulations, a prepayment meets the 
business purpose exception only if 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.
    Commentators suggested that the business purpose exception in the 
proposed regulations would have limited usefulness and that the 
language in the existing regulations is superior. However, as discussed 
in the preamble to the proposed regulations, the business purpose 
exception in the existing regulations was intended to be a narrow 
exception and has raised difficult interpretive questions. For example, 
in many instances it may be unclear whether the alternatives available 
to the issuer are ``commercially reasonable.'' The IRS and Treasury 
Department have considered all of the comments relating to the business 
purpose exception and have concluded that a standard that considers 
whether one or more business purposes and/or commercially reasonable 
alternatives exist is not an administrable test for determining whether 
prepayments give rise to investment-type property. Therefore, based on 
tax administration considerations and the broad scope of the 
investment-type property concept, the final regulations delete the 
business purpose exception. However, the final regulations provide that 
the Commissioner may, by published guidance, set forth additional 
circumstances in which a prepayment does not give rise to investment-
type property.
C. Customary Exception
    The proposed regulations retain the customary exception in its 
present form. Commentators expressed concern that the customary 
exception may be difficult to apply in some cases. They suggested that 
the regulations identify examples of prepayments that satisfy the 
exception. The final regulations retain the customary exception and 
indicate that it generally applies based on all the facts and 
circumstances. In addition, the final regulations contain a safe harbor 
under which a prepayment is deemed to satisfy the customary exception 
if: (1) The prepayment is made for maintenance, repair, or an extended 
warranty with respect to personal property (for example, automobiles or 
electronic equipment), or updates or maintenance or support services 
with respect to computer software; and (2) the same maintenance, 
repair, extended warranty, updates or maintenance or support services, 
as applicable, are regularly provided to nongovernmental persons on the 
same terms.
D. Certain Prepayments To Acquire a Supply of Natural Gas or 
Electricity
1. Prepayments for Natural Gas
    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, if 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 (the use requirement). 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.
    Some commentators recommended that the 95 percent threshold be 
reduced to 85 percent. These commentators stated that various factors 
make it difficult for municipal gas utilities to determine in advance 
the precise quantity of gas supplies they will need to serve their 
customers during a given period. These factors include a limited 
capability to store gas and variations in demand due to circumstances 
beyond the utilities' control, such as economic conditions and the 
weather. In recognition of these unique factors, the final regulations 
reduce the 95 percent threshold to 90 percent.
    Some commentators recommended that the use requirement apply based 
on the issuer's reasonable expectations as of the issue date. To ensure 
that the prepaid gas is consumed by retail customers in the service 
area of the municipal utility, the final regulations retain the 
requirement that the prepaid gas supply actually be used for a 
qualifying purpose.
    Some commentators suggested that the use of natural gas to fuel the 
transportation of the prepaid gas supply on a pipeline should be a 
qualifying use under the natural gas exception. The final regulations 
adopt this comment. Under the final regulations, the use of gas to fuel 
the pipeline transportation of the prepaid gas supply is a qualifying 
use and is not pro-rated based on the amount of qualified and 
nonqualified use of the remaining prepaid gas.
    Commentators indicated that most municipal gas and electric 
utilities do not have an obligation to serve that arises under state or 
Federal law. These commentators suggested replacing the ``obligation to 
serve'' requirement for municipal electric utilities with a service 
area rule that is similar to the rule for municipal gas utilities. The 
final regulations adopt this comment. Commentators also recommended 
that the definition of service area be expanded to include any area 
recognized as the service area of the municipal utility under state or 
Federal law. The final regulations adopt this comment.
    Commentators requested clarification that sales to governmental 
persons are qualifying sales under the use test. Commentators also 
requested clarification that a retail customer of a municipal utility 
is a qualifying end-user even if the prepayment was made by or for 
another municipal utility. The final regulations do not provide that 
all sales to governmental persons, or to retail customers of a 
municipal utility, are qualifying sales. Rather, the final regulations 
clarify that, in the case of a natural gas prepayment by or for one or 
more municipal utilities (each, the issuing municipal utility), the use 
of prepaid gas is a qualifying use if the gas is: (1) Furnished to 
retail gas customers of the issuing municipal utility who are located 
in the natural gas service area of the issuing municipal utility (other 
than sales of gas to produce electricity for sale); (2) used by the 
issuing municipal utility to produce electricity that will be furnished 
to retail electric customers of the issuing municipal utility who are 
located in the electricity service area of the issuing municipal 
utility; (3) used by the issuing municipal utility to produce 
electricity that will be sold to a municipal utility and furnished to 
retail electric customers of the purchaser who are located in the

[[Page 45774]]

electricity service area of the purchaser; (4) sold to a municipal 
utility if the requirements of (1), (2) or (3) of this paragraph are 
satisfied by the purchaser (treating the purchaser as the issuing 
municipal utility); or (5) used to fuel the transportation of the 
prepaid gas supply on a pipeline. Thus, for example, the sale of gas or 
electricity by the issuing municipal utility directly to customers of 
another municipal utility is not a qualifying use.
    Some commentators recommended that the final regulations define 
``retail customer'' as a customer that is not purchasing for resale. 
The final regulations provide that a retail customer is a customer that 
purchases natural gas or electricity, as applicable, other than for 
resale. The final regulations also clarify that the consumption of 
natural gas by a nongovernmental person to produce electricity for sale 
is not a qualifying use of natural gas under the 90 percent use test.
    Some commentators requested clarification of which ``contiguous'' 
areas may be treated as part of a municipal utility's service area. One 
commentator suggested that contiguous areas should not be considered 
part of the service area. To provide clarity, and in light of the 
expansion of the service area definition to include any area recognized 
as the service area under state or Federal law, the final regulations 
eliminate contiguous areas from the definition of service area.
    Some commentators suggested that the definition of service area 
should be expanded to include any area ``in which'' (rather than 
``throughout which'') the municipal utility provided service during the 
five-year period. To ensure that the gas or electricity is consumed by 
customers in an area recognized as the service area of a municipal 
utility under state or Federal law, or throughout which the municipal 
utility provided service during the five-year period, the final 
regulations do not adopt this comment.
2. Prepayments for Electricity
    Some commentators suggested that the natural gas exception should 
be expanded to include prepayments for electricity. These commentators 
stated that the restructuring of the electric power industry has 
affected municipal electric utilities in a manner that is similar to 
the effect that deregulation of the natural gas industry had on 
municipal gas utilities. These commentators stated that restructuring 
has threatened the ability of municipal electric utilities to obtain a 
secure supply of electric power on commercially reasonable terms, and 
that electric power prepayment transactions are necessary to obtain a 
guaranteed supply of electric power on favorable terms in light of 
restructuring.
    The final regulations add an exception to the definition of 
investment-type property for certain electricity prepayments that are 
made by or for one or more municipal utilities (for example, if a joint 
action agency acquires electricity for one or more municipal electric 
utilities). The exception applies only if at least 90 percent of the 
prepaid electricity financed by the issue is used for a qualifying use. 
For this purpose, electricity is used for a qualifying use if it is to 
be: (1) Furnished to retail electric customers of the issuing municipal 
utility who are located in the electricity service area of the issuing 
municipal utility; or (2) sold to a municipal utility and furnished to 
retail electric customers of the purchaser who are located in the 
electricity service area of the purchaser.
3. Remedial Actions
    The preamble to the proposed regulations states that issuers may 
apply principles similar to the rules of Sec.  1.141-12 to cure a 
violation of the use requirement. Commentators requested clarification 
regarding which remedies under Sec.  1.141-12 are available for this 
purpose. The final regulations provide that issuers may apply 
principles similar to the rules of Sec.  1.141-12 to cure a violation 
of the 90 percent use requirement, and that the ``redemption or 
defeasance'' remedy in Sec.  1.141-12(d) and the ``alternative use of 
disposition proceeds'' remedy in Sec.  1.141-12(e) are available for 
this purpose.
    Some commentators requested clarification of the amount of 
nonqualified bonds that must be redeemed or defeased under the 
``redemption or defeasance'' remedy. Under the final regulations, the 
amount of nonqualified bonds is determined in the same manner as for 
output contracts taken into account under the private business tests, 
including the principles of Sec.  1.141-7(d), treating nonqualified 
sales of gas or electricity as satisfying the benefits and burdens test 
under Sec.  1.141-7(c)(1). Commentators also suggested that the 
definition of ``nonqualified bonds'' under Sec.  1.141-12 may require 
excessive amounts of bonds to be retired. The IRS and Treasury 
Department are considering this comment in connection with possible 
amendments to Sec.  1.141-12.
4. Commodity Swap Contracts
    The proposed regulations provide that a transaction will not fail 
to qualify for the natural gas 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, the 
proposed regulations provide that 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). Notice 2002-52 (2002-
30 I.R.B. 187), provides that a natural gas commodity swap contract 
will not fail to be an independent contract solely because the swap 
contract may terminate in the event of a failure of a gas supplier to 
deliver gas for which the swap contract is a hedge.
    Commentators generally agreed with the provision on swap contracts 
in the proposed regulations, as modified by Notice 2002-52. The final 
regulations retain the provision on commodity swap contracts for 
natural gas prepayments, as modified by Notice 2002-52, and expand it 
to apply to electricity prepayments.
E. De Minimis Prepayments
    The proposed regulations add an exception for prepayments made 
within 90 days of the date of delivery of all the property or services 
to which the prepayment relates. Commentators recommended that the 
exception apply based on reasonable expectations. The final regulations 
adopt this comment. This change to a reasonable expectations standard 
is intended to permit a prepayment to qualify for the de minimis 
exception even if an unexpected event beyond the control of the issuer 
causes delivery of the property or services to be delayed beyond the 
90-day period. The reasonable expectations standard does not, however, 
apply to any change to the terms of the prepayment other than an 
unexpected delay in delivery.

II. Private Loans

    The existing regulations, at Sec.  1.141-5(c)(2)(ii), provide rules 
for determining whether a prepayment for property or services is 
treated as a loan for purposes of the private loan financing test. The 
existing regulations for private loans are similar to the existing 
regulations in

[[Page 45775]]

Sec.  1.148-1(e)(2) for determining whether a prepayment gives rise to 
investment-type property, except that the private loan regulations 
focus on whether the prepayment provides a benefit of tax-exempt 
financing to the seller. The final 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 the final regulations.

III. Tables of Contents

    The final regulations amend the tables of contents in Sec. Sec.  
1.141-0 and 1.148-0 to reflect the final regulations and certain 
previously issued regulations under sections 141 and 148.

Effective Dates

    The final regulations apply to bonds sold on or after October 3, 
2003. In addition, issuers may apply the final regulations to bonds 
sold before October 3, 2003 that are subject to Sec. Sec.  1.141-5 and 
1.148-1.

Special Analyses

    It has been determined that this Treasury decision 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 Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
rule does not impose a collection of information on small entities, the 
provisions of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.) do 
not apply.

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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.141-0 is amended by revising the entry for Sec.  
1.141-15(b) to read as follows:


Sec.  1.141-0  Table of contents.

* * * * *

Sec.  1.141-15 Effective dates.

    (b) Effective dates.
    (1) In general.
    (2) Certain short-term arrangements.
    (3) Certain prepayments.
* * * * *

0
Par. 3. In Sec.  1.141-5, paragraph (c)(2)(ii) is revised and 
paragraphs (c)(2)(iii) and (c)(2)(iv) are added to 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) 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;
    (B) The prepayment is made within 90 days of the reasonably 
expected date of delivery to the issuer of all of the property or 
services for which the prepayment is made; or
    (C) The prepayment meets the requirements of Sec.  1.148-
1(e)(2)(iii)(A) or (B) (relating to certain prepayments to acquire a 
supply of natural gas or electricity).
    (iii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (c)(2)(ii)(A) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (c)(2)(ii)(A) of this section 
if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); 
or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iv) 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.
* * * * *

0
Par. 4. Section 1.141-15 is amended by adding paragraph (b)(3) to read 
as follows:


Sec.  1.141-15  Effective dates.

* * * * *
    (b) * * *
    (3) Certain prepayments. Except as provided in paragraph (c) of 
this section, paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of 
Sec.  1.141-5 apply to bonds sold on or after October 3, 2003. Issuers 
may apply paragraphs (c)(2)(ii), (c)(2)(iii) and (c)(2)(iv) of Sec.  
1.141-5, in whole but not in part, to bonds sold before October 3, 2003 
that are subject to Sec.  1.141-5.

0
Par. 5. Section 1.148-0 is amended by:
0
1. Adding entries in paragraph (c) for Sec.  1.148-1, paragraphs (e)(1) 
through (e)(3).
0
2. Adding entries in paragraph (c) for Sec.  1.148-11, paragraphs 
(b)(4), (h), (i) and (j).
    The additions read as follows:


Sec.  1.148-0  Scope and table of contents.

* * * * *
    (c) Table of contents.
* * * * *

Sec.  1.148-1 Definitions and elections.

* * * * *
    (e) * * *
    (1) In general.
    (2) Prepayments.
    (3) Certain hedges.
* * * * *

Sec.  1.148-11 Effective dates.

    (b) * * *
    (4) No elective retroactive application for safe harbor for 
establishing fair market value for guaranteed investment contracts 
and investments purchased for a yield restricted defeasance escrow.
* * * * *
    (h) Safe harbor for establishing fair market value for 
guaranteed investment contracts and investments purchased for a 
yield restricted defeasance escrow.
    (i) Special rule for investments purchased for a yield 
restricted defeasance escrow.
    (j) Certain prepayments.

0
Par. 6. In Sec.  1.148-1, paragraphs (e)(1) and (2) are revised to read 
as follows:


Sec.  1.148-1  Definitions and elections.

* * * * *

[[Page 45776]]

    (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--(A) Generally. 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 
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--
    (1) 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;
    (2) The prepayment is made within 90 days of the reasonably 
expected date of delivery to the issuer of all of the property or 
services for which the prepayment is made; or
    (3) The prepayment meets the requirements of paragraph 
(e)(2)(iii)(A) or (B) of this section.
    (B) Example. The following example illustrates an application of 
this paragraph (e)(2)(i):

    Example. 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.

    (ii) Customary prepayments. The determination of whether a 
prepayment satisfies paragraph (e)(2)(i)(A)(1) of this section is 
generally made based on all the facts and circumstances. In addition, a 
prepayment is deemed to satisfy paragraph (e)(2)(i)(A)(1) of this 
section if--
    (A) The prepayment is made for--
    (1) Maintenance, repair, or an extended warranty with respect to 
personal property (for example, automobiles or electronic equipment); 
or
    (2) Updates or maintenance or support services with respect to 
computer software; and
    (B) The same maintenance, repair, extended warranty, updates or 
maintenance or support services, as applicable, are regularly provided 
to nongovernmental persons on the same terms.
    (iii) Certain prepayments to acquire a supply of natural gas or 
electricity--(A) Natural gas prepayments. A prepayment meets the 
requirements of this paragraph (e)(2)(iii)(A) 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) (each of which is 
referred to in this paragraph (e)(2)(iii)(A) as the issuing municipal 
utility), to purchase a supply of natural gas; and
    (2) At least 90 percent of the prepaid natural gas financed by the 
issue is used for a qualifying use. Natural gas is used for a 
qualifying use if it is to be--
    (i) Furnished to retail gas customers of the issuing municipal 
utility who are located in the natural gas service area of the issuing 
municipal utility, provided, however, that gas used to produce 
electricity for sale shall not be included under this paragraph 
(e)(2)(iii)(A)(2)(i);
    (ii) Used by the issuing municipal utility to produce electricity 
that will be furnished to retail electric customers of the issuing 
municipal utility who are located in the electricity service area of 
the issuing municipal utility;
    (iii) Used by the issuing municipal utility to produce electricity 
that will be sold to a utility that is owned by a governmental person 
and furnished to retail electric customers of the purchaser who are 
located in the electricity service area of the purchaser;
    (iv) Sold to a utility that is owned by a governmental person if 
the requirements of paragraph (e)(2)(iii)(A)(2)(i), (ii) or (iii) of 
this section are satisfied by the purchaser (treating the purchaser as 
the issuing municipal utility); or
    (v) Used to fuel the pipeline transportation of the prepaid gas 
supply acquired in accordance with this paragraph (e)(2)(iii)(A).
    (B) Electricity prepayments. A prepayment meets the requirements of 
this paragraph (e)(2)(iii)(B) if--
    (1) It is made by or for one or more utilities that are owned by a 
governmental person (each of which is referred to in this paragraph 
(e)(2)(iii)(B) as the issuing municipal utility) to purchase a supply 
of electricity; and
    (2) At least 90 percent of the prepaid electricity financed by the 
issue is used for a qualifying use. Electricity is used for a 
qualifying use if it is to be--
    (i) Furnished to retail electric customers of the issuing municipal 
utility who are located in the electricity service area of the issuing 
municipal utility; or
    (ii) Sold to a utility that is owned by a governmental person and 
furnished to retail electric customers of the purchaser who are located 
in the electricity service area of the purchaser.
    (C) Service area. For purposes of this paragraph (e)(2)(iii), the 
service area of a utility owned by a governmental person consists of--
    (1) Any area throughout which the utility provided, at all times 
during the 5-year period ending on the issue date--
    (i) In the case of a natural gas utility, natural gas transmission 
or distribution service; and
    (ii) In the case of an electric utility, electricity distribution 
service; and
    (2) Any area recognized as the service area of the utility under 
state or Federal law.
    (D) Retail customer. For purposes of this paragraph (e)(2)(iii), a 
retail customer is a customer that purchases natural gas or 
electricity, as applicable, other than for resale.
    (E) Commodity swaps. A prepayment does not fail to meet the 
requirements of this paragraph (e)(2)(iii) by reason of any commodity 
swap contract that may be entered into between the issuer and an 
unrelated party (other than the gas or electricity supplier), or 
between the gas or electricity 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 or electricity 
supply contract or another swap contract); provided, however, that a 
commodity swap contract will not fail to be an independent contract 
solely because the swap contract may terminate in the event of a 
failure of a gas or electricity supplier to deliver gas or electricity 
for which the swap contract is a hedge.
    (F) Remedial action. Issuers may apply principles similar to the 
rules of Sec.  1.141-12, including Sec.  1.141-12(d) (relating to 
redemption or defeasance of nonqualified bonds) and Sec.  1.141-12(e) 
(relating to alternative use of disposition proceeds), to cure a 
violation of paragraph (e)(2)(iii)(A)(2) or (e)(2)(iii)(B)(2) of this 
section. For this purpose, the amount of nonqualified bonds is 
determined in the same

[[Page 45777]]

manner as for output contracts taken into account under the private 
business tests, including the principles of Sec.  1.141-7(d), treating 
nonqualified sales of gas or electricity under this paragraph 
(e)(2)(iii) as satisfying the benefits and burdens test under Sec.  
1.141-7(c)(1).
    (iv) 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.
* * * * *
    Par. 7. Section 1.148-11 is amended by adding paragraph (j) to read 
as follows:


Sec.  1.148-11  Effective dates.

* * * * *
    (j) Certain prepayments. Section 1.148-1(e)(1) and (2) apply to 
bonds sold on or after October 3, 2003. Issuers may apply Sec.  1.148-
1(e)(1) and (2), in whole but not in part, to bonds sold before October 
3, 2003 that are subject to Sec.  1.148-1.

Dale F. Hart,
Acting Deputy Commissioner for Services and Enforcement.
    Approved: July 25, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-19644 Filed 8-1-03; 8:45 am]
BILLING CODE 4830-01-P