[Federal Register Volume 68, Number 238 (Thursday, December 11, 2003)]
[Rules and Regulations]
[Pages 69020-69024]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-30635]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9097]
RIN 1545-AX22


Arbitrage Restrictions Applicable to Tax-Exempt Bonds Issued by 
State and Local Governments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations on the arbitrage 
restrictions applicable to tax-exempt bonds issued by state and local 
governments. The regulations affect issuers of tax-exempt bonds and 
provide a safe harbor for qualified administrative costs for broker's 
commissions and similar fees incurred in connection with the 
acquisition of guaranteed investment contracts or investments purchased 
for a yield restricted defeasance escrow.

DATES: Effective Date: These regulations are effective February 9, 
2004.
    Applicability Date: For dates of applicability, see Sec.  1.148-
11(i) of these regulations.

FOR FURTHER INFORMATION CONTACT: Rose M. Weber, (202) 622-3980 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document amends 26 CFR part 1 under section 148 of the 
Internal Revenue Code by providing rules for determining when certain 
brokers' commissions or similar fees are qualified administrative costs 
(the final regulations). On August 27, 1999, the IRS published in the 
Federal Register a notice of proposed rulemaking (REG-105565-99)(64 FR 
46876) (the proposed regulations). The proposed regulations modify 
Sec.  1.148-5(e)(2) to provide a safe harbor for determining whether 
brokers' commissions and similar fees incurred in connection with the 
acquisition of guaranteed investment contracts or investments purchased 
for a yield restricted defeasance escrow are treated as qualified 
administrative costs. Comments on the proposed regulations were 
received and a hearing was held on December 14, 1999. After 
consideration of all the comments, the proposed regulations are adopted 
as revised by this Treasury decision. The revisions are discussed 
below.

Explanation of Provisions

I. Existing Regulations

A. Investment Yield and Administrative Costs
    Section 148 limits the yield on investments purchased with proceeds 
of tax-exempt bonds. In general, under Sec.  1.148-5(b)(1) of the 
existing regulations, the yield on an investment is computed by 
comparing receipts from the investment to payments for the investment. 
Section 1.148-5(e)(1) provides that the yield on an investment 
generally is not adjusted to take into account any costs or expenses 
paid, directly or indirectly, to purchase, carry, sell, or retire the 
investment (administrative costs). However, Sec.  1.148-5(e)(2)(i) 
provides that the yield on nonpurpose investments (as defined in Sec.  
1.148-1(b)) is adjusted to take into account qualified administrative 
costs. Qualified administrative costs are reasonable, direct 
administrative costs, other than carrying costs, such as separately 
stated brokerage or selling commissions, but not legal and accounting 
fees, recordkeeping, custody, and similar costs. In general, under 
Sec.  1.148-5(e)(2)(i), administrative costs are not reasonable unless 
they are comparable to administrative costs that would be charged for 
the same investment or a reasonably comparable investment if acquired 
with a source of funds other than gross proceeds of tax-exempt bonds 
(the comparability standard).
B. Special Rule for Guaranteed Investment Contracts
    Section 1.148-5(e)(2)(iii) of the existing regulations provides 
that, for a guaranteed investment contract, a broker's commission or 
similar fee paid on behalf of either an issuer or the guaranteed 
investment contract provider generally is a qualified administrative

[[Page 69021]]

cost to the extent that the present value of the commission, as of the 
date the contract is allocated to the issue, does not exceed the lesser 
of (x) a reasonable amount within the meaning of Sec.  1.148-5(e)(2)(i) 
or (y) the present value of annual payments equal to .05 percent of the 
weighted average amount reasonably expected to be invested each year of 
the term of the contract. Present value is computed using the taxable 
discount rate used by the parties to compute the commission, or if not 
readily ascertainable, the yield to the issuer on the investment 
contract or other reasonable taxable discount rate.
C. Special Rule for Yield Restricted Defeasance Escrows
    Section 1.148-5(e)(2)(iv) of the existing regulations provides 
that, for investments purchased for a yield restricted defeasance 
escrow, a fee paid to a bidding agent is a qualified administrative 
cost only if the fee is comparable to a fee that would be charged for a 
reasonably comparable investment if acquired with a source of funds 
other than gross proceeds of tax-exempt bonds, and it is reasonable. 
The fee is deemed to meet both the comparability and reasonableness 
requirements if it does not exceed the lesser of $10,000 or .1 percent 
of the initial principal amount of investments deposited in the yield 
restricted defeasance escrow.

II. Proposed Regulations

    The proposed regulations were issued in response to comments 
stating that issuers were having difficulty applying Sec.  1.148-
5(e)(2)(iii) and (iv), primarily because of uncertainty about whether a 
particular broker's commission or similar fee is reasonable. The 
proposed regulations delete the existing provisions of Sec.  1.148-
5(e)(2)(iii) and (iv) and create a single rule for qualified 
administrative costs that treats a broker's commission or similar fee 
incurred in connection with a guaranteed investment contract or 
investments purchased for a yield restricted defeasance escrow as a 
qualified administrative cost if the fee is reasonable within the 
meaning of Sec.  1.148-5(e)(2)(i) of the existing regulations.
    The proposed regulations also set forth a safe harbor, which treats 
a broker's commission or similar fee incurred in connection with the 
acquisition of a guaranteed investment contract or investments 
purchased for a yield restricted defeasance escrow as reasonable within 
the meaning of Sec.  1.148-5(e)(2)(i) if two requirements are met. 
Under the first requirement for the safe harbor, the amount of the 
broker's commission or similar fee treated by the issuer as a qualified 
administrative cost cannot exceed the lesser of $25,000 or 0.2 percent 
of the computational base (the per-investment safe harbor). For 
guaranteed investment contracts, the computational base is the 
aggregate amount reasonably expected as of the issue date to be 
deposited over the term of the contract. For example, for a guaranteed 
investment contract used to earn a return on what otherwise would be 
idle cash balances from maturing investments in a yield restricted 
defeasance escrow, the aggregate amount reasonably expected to be 
deposited includes all periodic deposits reasonably expected to be made 
pursuant to the terms of the contract. For investments, other than 
guaranteed investment contracts, deposited in a yield restricted 
defeasance escrow, the computational base is the initial amount 
invested in those investments. Under the second requirement for the 
safe harbor, for any issue of bonds, the issuer cannot treat as 
qualified administrative costs more than $75,000 in brokers' 
commissions or similar fees with respect to all guaranteed investment 
contracts and investments for yield restricted defeasance escrows 
purchased with gross proceeds of the issue (the per-issue safe harbor).

III. Final Regulations

A. Safe Harbor Approach
    Some commentators suggested that the existing regulations, coupled 
with competitive market forces, work well to produce reasonable 
brokers' fees. Commentators also suggested that the proposed 
regulations will eliminate much of the incentive for the independent 
bidding agent to actively participate in the market, with the result 
that, in many cases, tax-exempt bond proceeds will be placed in lower-
yielding and often riskier investments. These commentators recommended 
against adopting the safe harbor in the proposed regulations.
    Other commentators suggested that the existing regulations do not 
work well. They stated that the current rules provide little practical 
guidance upon which an issuer can rely to determine whether a broker's 
fee for a guaranteed investment contract is a reasonable amount. These 
commentators recommended that the safe harbor be adopted with 
modifications. They suggested that the safe harbor will provide a much 
needed level of certainty.
    The IRS and Treasury Department do not believe the final 
regulations will result in tax-exempt bond proceeds being invested in 
low-yielding, risky investments because the regulations do not 
adversely affect an issuer's incentive to realize investment earnings 
and to invest in secure investments. To provide simplicity and 
certainty, the final regulations retain the safe harbor, with certain 
modifications discussed below. The final regulations do not limit the 
amount of brokers' fees that may be paid by issuers. Thus, for example, 
the final regulations do not restrict the ability of an issuer to pay a 
particular fee that exceeds the safe harbor amount. Furthermore, 
brokers' commissions or similar fees in excess of the safe harbor are 
qualified administrative costs if they are reasonable within the 
meaning of Sec.  1.148-5(e)(2)(i).
B. Per-Investment Safe Harbor
    Commentators suggested that, if the per-investment safe harbor is 
retained, it should be increased. These commentators stated that in 
some circumstances the safe harbor does not reflect the value provided 
by brokers, particularly in the case of small or large transactions and 
long-term debt service reserve fund investments. Suggestions for 
modifying the per-investment safe harbor included adding a minimum fee 
for smaller transactions and a sliding scale for larger transactions. 
Commentators also suggested increasing the computational base for long-
term guaranteed investment contracts by treating them as a series of 
shorter-term contracts.
    The final regulations increase the $25,000 amount to $30,000 and 
provide for a minimum fee of $3,000. Thus, if 0.2 percent of the 
computational base is less than $3,000, the per-investment safe harbor 
is $3,000. The final regulations do not adopt a sliding scale and do 
not treat long-term contracts as a series of shorter-term contracts 
because the IRS and Treasury Department have concluded that the per-
investment safe harbor in the final regulations provides much needed 
certainty without requiring issuers to pay less than fair market value 
for brokers' fees.
C. Per-Issue Safe Harbor
    Commentators recommended that the per-issue safe harbor be 
increased or eliminated. Some commentators suggested replacing the per-
issue safe harbor with an anti-abuse rule to prevent the artificial 
creation of multiple investments when a single investment would be 
appropriate. Suggestions included aggregating separate investments that 
(1) are made at or about the same time if the bond proceeds being 
invested have similar

[[Page 69022]]

rebate or yield characteristics, or (2) would normally be bid together 
as a single investment unless there was a good business reason for the 
separation.
    The final regulations retain the per-issue safe harbor and increase 
the $75,000 amount to $85,000. To maintain simplicity and certainty, 
the final regulations do not adopt the suggestion to replace the per-
issue safe harbor with an anti-abuse rule. The IRS and Treasury 
Department have concluded that the per-issue safe harbor in the final 
regulations limits artificial separation of investments without 
requiring issuers to pay less than fair market value for brokers' fees.
D. Fees in Excess of Safe Harbor
    Some commentators requested guidance on the factors for determining 
whether a fee in excess of the safe harbor is reasonable. Suggested 
factors included the duration of the contract, the complexity of its 
terms, the creditworthiness of the issuer, the availability of 
providers to deliver the contract, the presence of unusual features in 
the issue or the contract, custom in the industry, and the level of 
risk to the broker. The IRS and Treasury Department have considered the 
suggested factors and have concluded that they do not represent 
administrable standards for determining whether a particular fee is 
reasonable. Therefore, the final regulations do not specify factors for 
determining the reasonableness of fees in excess of the safe harbor. 
Under the final regulations, the determination of whether a fee is 
reasonable is made based on all the facts and circumstances, including 
whether the fee satisfies the comparability standard in Sec.  1.148-
5(e)(2)(i).
    Some commentators suggested that the portion of a fee that is 
within the safe harbor should be a qualified administrative cost, even 
if the total fee exceeds the safe harbor. The final regulations adopt 
this suggestion.
E. Computational Base for Guaranteed Investment Contracts
    Commentators suggested that the computational base for a guaranteed 
investment contract should be determined as of the date the contract is 
acquired, rather than the issue date, so that the safe harbor may be 
applied to guaranteed investment contracts that are not anticipated on 
the issue date. The final regulations adopt this suggestion.
F. Cost-of-Living Adjustments
    Commentators requested that the final regulations provide for 
periodic adjustments to the dollar limits in the safe harbor to reflect 
inflation. The final regulations provide a cost-of-living adjustment 
for both the per-investment safe harbor and the per-issue safe harbor. 
The adjusted safe harbor dollar amounts will be published in the annual 
revenue procedure that sets forth inflation-adjusted items.
G. Interpretative Rule
    One commentator questioned whether the proposed regulations should 
have been classified as a legislative rule. The IRS and Treasury 
Department have reviewed the applicable authorities and have determined 
that the regulations are properly classified as an interpretative rule.

Effective Dates

    The final regulations apply to bonds sold on or after February 9, 
2004. In the case of bonds sold before February 9, 2004, that are 
subject to Sec.  1.148-5 (pre-effective date bonds), issuers may apply 
the final regulations, in whole but not in part, with respect to 
transactions entered into on or after December 11, 2003. If an issuer 
applies the final regulations to pre-effective date bonds, the per-
issue safe harbor is applied by taking into account all brokers' 
commissions or similar fees with respect to guaranteed investment 
contracts and investments for yield restricted defeasance escrows that 
the issuer treats as qualified administrative costs for the issue, 
including all such commissions or fees paid before February 9, 2004. 
For purposes of Sec. Sec.  1.148-5(e)(2)(iii)(B)(3) and 1.148-
5(e)(2)(iii)(B)(6) of the final regulations (relating to cost-of-living 
adjustments), transactions entered into before 2003 are treated as 
entered into in 2003.

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. chapter 6) do 
not apply.

Drafting Information

    The principal authors of these final regulations are Rose M. Weber 
and Rebecca L. Harrigal, Office of Chief Counsel, IRS (TE/GE), 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
1. The authority citation for part 1 continues to read in part as 
follows:

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


0
2. Section 1.148-0 is amended by revising the entry in paragraph (c) 
for Sec.  1.148-11 (i) to read as follows:


Sec.  1.148-0  Scope and table of contents.

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


Sec.  1.148-11  Effective dates.

* * * * *

    (i) Special rule for certain broker's commissions and similar 
fees.

* * * * *

0
3. In Sec.  1.148-5, paragraph (e) is amended as follows:
0
1. Paragraph (e)(2)(iii) is revised.
0
2. Paragraph (e)(2)(iv) is removed.
    The revision reads as follows:


Sec.  1.148-5  Yield and valuation of investments.

* * * * *
    (e) * * *
    (2) * * *
    (iii) Special rule for guaranteed investment contracts and 
investments purchased for a yield restricted defeasance escrow--(A) In 
general. An amount paid for a broker's commission or similar fee with 
respect to a guaranteed investment contract or investments purchased 
for a yield restricted defeasance escrow is a qualified administrative 
cost if the fee is reasonable within the meaning of paragraph (e)(2)(i) 
of this section.
    (B) Safe harbor--(1) In general. A broker's commission or similar 
fee with respect to the acquisition of a guaranteed investment contract 
or investments purchased for a yield restricted defeasance escrow is 
reasonable within the meaning of paragraph (e)(2)(i) of this section to 
the extent that--
    (i) The amount of the fee that the issuer treats as a qualified 
administrative cost does not exceed the lesser of:
    (A) $30,000 and
    (B) 0.2% of the computational base or, if more, $3,000; and

[[Page 69023]]

    (ii) For any issue, the issuer does not treat as qualified 
administrative costs more than $85,000 in brokers' commissions or 
similar fees with respect to all guaranteed investment contracts and 
investments for yield restricted defeasance escrows purchased with 
gross proceeds of the issue.
    (2) Computational base. For purposes of paragraph (e)(2)(iii)(B)(1) 
of this section, computational base shall mean--
    (i) For a guaranteed investment contract, the amount of gross 
proceeds the issuer reasonably expects, as of the date the contract is 
acquired, to be deposited in the guaranteed investment contract over 
the term of the contract, and
    (ii) For investments (other than guaranteed investment contracts) 
to be deposited in a yield restricted defeasance escrow, the amount of 
gross proceeds initially invested in those investments.
    (3) Cost-of-living adjustment. In the case of a calendar year after 
2004, each of the dollar amounts in paragraph (e)(2)(iii)(B)(1) of this 
section shall be increased by an amount equal to--
    (i) Such dollar amount; multiplied by
    (ii) The cost-of-living adjustment determined under section 1(f)(3) 
for such calendar year by using the language ``calendar year 2003'' 
instead of ``calendar year 1992'' in section 1(f)(3)(B).
    (4) Rounding. If any increase determined under paragraph 
(e)(2)(iii)(B)(3) of this section is not a multiple of $1,000, such 
increase shall be rounded to the nearest multiple thereof.
    (5) Applicable year for cost-of-living adjustment. The cost-of-
living adjustments under paragraph (e)(2)(iii)(B)(3) of this section 
shall apply to the safe harbor amounts under paragraph 
(e)(2)(iii)(B)(1) of this section based on the year the guaranteed 
investment contract or the investments for the yield restricted 
defeasance escrow, as applicable, are acquired.
    (6) Cost-of-living adjustment to determine remaining amount of per-
issue safe harbor--(i) In general. This paragraph (e)(2)(iii)(B)(6) 
applies to determine the portion of the safe harbor amount under 
paragraph (e)(2)(iii)(B)(1)(ii) of this section, as modified by 
paragraph (e)(2)(iii)(B)(3) of this section (the per-issue safe 
harbor), that is available (the remaining amount) for any year (the 
determination year) if the per-issue safe harbor was partially used in 
one or more prior years.
    (ii) Remaining amount of per-issue safe harbor. The remaining 
amount of the per-issue safe harbor for any determination year is equal 
to the per-issue safe harbor for that year, reduced by the portion of 
the per-issue safe harbor used in one or more prior years.
    (iii) Portion of per-issue safe harbor used in prior years. The 
portion of the per-issue safe harbor used in any prior year (the prior 
year) is equal to the total amount of broker's commissions or similar 
fees paid in connection with guaranteed investment contracts or 
investments for a yield restricted defeasance escrow acquired in the 
prior year that the issuer treated as qualified administrative costs 
for the issue, multiplied by a fraction the numerator of which is the 
per-issue safe harbor for the determination year and the denominator of 
which is the per-issue safe harbor for the prior year. See paragraph 
(e)(2)(iii)(C) Example 2 of this section.
    (C) Examples. The following examples illustrate the application of 
the safe harbor in paragraph (e)(2)(iii)(B) of this section:

    Example 1. Multipurpose issue. In 2003, the issuer of a 
multipurpose issue uses brokers to acquire the following investments 
with gross proceeds of the issue: a guaranteed investment contract 
for amounts to be deposited in a construction fund (construction 
GIC), Treasury securities to be deposited in a yield restricted 
defeasance escrow (Treasury investments) and a guaranteed investment 
contract that will be used to earn a return on what otherwise would 
be idle cash balances from maturing investments in the yield 
restricted defeasance escrow (the float GIC). The issuer deposits 
$22,000,000 into the construction GIC and reasonably expects that no 
further deposits will be made over its term. The issuer uses 
$8,040,000 of the proceeds to purchase the Treasury investments. The 
issuer reasonably expects that it will make aggregate deposits of 
$600,000 to the float GIC over its term. The brokers' fees are 
$30,000 for the construction GIC, $16,080 for the Treasury 
investments and $3,000 for the float GIC. The issuer has not 
previously treated any brokers' commissions or similar fees as 
qualified administrative costs. The issuer may claim all $49,080 in 
brokers' fees for these investments as qualified administrative 
costs because the fees do not exceed the safe harbors in paragraph 
(e)(2)(iii)(B) of this section. Specifically, each of the brokers' 
fees equals the lesser of $30,000 and 0.2% of the computational base 
(or, if more, $3,000) (i.e., lesser of $30,000 and 0.2% x 
$22,000,000 for the construction GIC; lesser of $30,000 and 0.2% x 
$8,040,000 for the Treasury investments; and lesser of $30,000 and 
$3,000 for the float GIC). In addition, the total amount of brokers' 
fees claimed by the issuer as qualified administrative costs 
($49,080) does not exceed the per-issue safe harbor of $85,000.
    Example 2. Cost-of-living adjustment. In 2003, an issuer issues 
bonds and uses gross proceeds of the issue to acquire two guaranteed 
investment contracts. The issuer pays a total of $50,000 in brokers' 
fees for the two guaranteed investment contracts and treats these 
fees as qualified administrative costs. In a year subsequent to 2003 
(Year Y), the issuer uses gross proceeds of the issue to acquire two 
additional guaranteed investment contracts, paying a total of 
$20,000 in broker's fees for the two guaranteed investment 
contracts, and treats those fees as qualified administrative costs. 
For Year Y, applying the cost-of-living adjustment under paragraph 
(e)(2)(iii)(B)(3) of this section, the safe harbor dollar limits 
under paragraph (e)(2)(iii)(B)(1) of this section are $3,000, 
$32,000 and $90,000. The remaining amount of the per-issue safe 
harbor for Year Y is $37,059 ($90,000-[$50,000 x $90,000/$85,000]). 
The broker's fees in Year Y do not exceed the per-issue safe harbor 
under paragraph (e)(2)(iii)(B)(1)(ii) (as modified by paragraph 
(e)(2)(iii)(B)(3)) of this section because the broker's fees do not 
exceed the remaining amount of the per-issue safe harbor determined 
under paragraph (e)(2)(iii)(B)(6) of this section for Year Y. In a 
year subsequent to Year Y (Year Z), the issuer uses gross proceeds 
of the issue to acquire an additional guaranteed investment 
contract, pays a broker's fee of $15,000 for the guaranteed 
investment contract, and treats the broker's fee as a qualified 
administrative cost. For Year Z, applying the cost-of-living 
adjustment under paragraph (e)(2)(iii)(B)(3) of this section, the 
safe harbor dollar limits under paragraph (e)(2)(iii)(B)(1) of this 
section are $3,000, $33,000 and $93,000. The remaining amount of the 
per-issue safe harbor for Year Z is $17,627 ($93,000--[($50,000 x 
$93,000/$85,000) + ($20,000 x $93,000/$90,000)]). The broker's fee 
incurred in Year Z does not exceed the per-issue safe harbor under 
paragraph (e)(2)(iii)(B)(1)(ii) (as modified by paragraph 
(e)(2)(iii)(B)(3)) of this section because the broker's fee does not 
exceed the remaining amount of the per-issue safe harbor determined 
under paragraph (e)(2)(iii)(B)(6) of this section for Year Z. See 
paragraph (e)(2)(iii)(B)(6) of this section.
* * * * *

0
4. Section 1.148-11 is amended by revising paragraph (i) to read as 
follows:


Sec.  1.148-11  Effective dates.

* * * * *
    (i) Special rule for certain broker's commissions and similar fees. 
Section 1.148-5(e)(2)(iii) applies to bonds sold on or after February 
9, 2004. In the case of bonds sold before February 9, 2004, that are 
subject to Sec.  1.148-5 (pre-effective date bonds), issuers may apply 
Sec.  1.148-5(e)(2)(iii), in whole but not in part, with respect to 
transactions entered into on or after December 11, 2003. If an issuer 
applies Sec.  1.148-5(e)(2)(iii) to pre-effective date bonds, the per-
issue safe harbor in Sec.  1.148-5(e)(2)(iii)(B)(1)(ii) is applied by 
taking into account all brokers' commissions or similar fees with 
respect to guaranteed investment contracts and investments for yield 
restricted defeasance escrows

[[Page 69024]]

that the issuer treats as qualified administrative costs for the issue, 
including all such commissions or fees paid before February 9, 2004. 
For purposes of Sec. Sec.  1.148-5(e)(2)(iii)(B)(3) and 1.148-
5(e)(2)(iii)(B)(6) (relating to cost-of-living adjustments), 
transactions entered into before 2003 are treated as entered into in 
2003.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: December 2, 2003.
Gregory Jenner,
Deputy Assistant Secretary of the Treasury.
[FR Doc. 03-30635 Filed 12-10-03; 8:45 am]
BILLING CODE 4830-01-P